To Her Majesty, The Queen

Buckingham Palace, London

Madam,

 

The disarming question you asked when you visited the London School of Economics last autumn – why did nobody notice that the credit crunch was on its way? – produced a thoughtful letter from the various authorities who gathered recently at the British Academy to ponder and draft a measured answer.

A panel of economists, regulators, market participants and journalists examined the usual suspects among the leading causes – global imbalances, technological optimism, deregulatory zeal, euphoria and hubris – and concluded that overspecialization among experts was the real culprit. The unanticipated virulence of the crisis derived from “the failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”

A new “horizon-scanning capability” was to be desired, the letter-writers said, “so that you never need to ask your question again.” Officials from the Treasury, the Bank of England, the Financial Services Authority, the Cabinet Office and the Department for Business, Innovation and Skills might well put their heads together to devise such a shared capacity to keep in sight the bigger picture, the letter-writers concluded.

With all due respect, Ma’am, I thought you might like to wish to see a parallax view. Journalists’ opinions sometimes differ from those of the experts whom they cover. That is the case here. A serviceable version of that horizon-scanning apparatus already exists. A longstanding tradition of literary and historical economics can be said to have given ample warning, not only that a crisis was to be expected, but, in this case, of the direction from which such a crisis could be expected to emerge. I am thinking of one book in particular

It was in 1978 that Charles P. Kindleberger’s Manias, Panics, and Crashes: A History of Financial Crises first appeared. A professor of economics at the Massachusetts Institute of Technology, Kindleberger, took as his epigraph a passage from Walter Bagehot’s “Essay on Edward Gibbon:”

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; and there is a “plethora”; it finds someone and there is “speculation”; it is devoured, and there is “panic.”

In the nineteenth century, wrote Kindleberger, there had been hardly any more familiar topic in economics than financial crises. John Stuart Mill, Alfred Marshall, Knut Wicksell and, in the twentieth century, Irving Fisher had offered literary accounts of how speculative manias (“overtrading,” as it was known in the time of Adam Smith) might lead to crisis and collapse. After World War II, however, the topic had fallen into disuse and disrepair, because financial crises had become so few and far between. In the 1950s and 1960s, even recessions were mild and short-lived. Business cycle peaks often failed to produce any real crisis at all.

But since the sharp worldwide recession of 1974-75, Kindleberger wrote, interest in the topic had revived; an opportunity to re-open the discussion was at hand, especially if the frequency and severity of crises were to increase. He took the plunge. Though a historical and literary economist himself, Kindleberger employed a formal model devised by Hyman Minsky, a monetary theorist then at Washington University, in St. Louis, to demonstrate how the classical discussion could be linked to the modern mathematical tradition.

Among other monetary theorists, Kindleberger noted, Minsky was known as being “particularly pessimistic, even lugubrious” in his conviction that modern capitalism was forever prone to shake itself apart, but the important thing was that his model had the basic elements necessary to describe the mechanics of mania, panics and crashes, including a role for debt, especially the aggressive form of borrowing to acquire speculative assets known as leverage.

That so few crises had taken place in the century before owed to Bagehot himself, as much as to any other single person, wrote Kindleberger, for it was the legendary editor of The Economist who clarified and made respectable the concept of the lender of last resort. Bagehot wrote Lombard Street: A Description of the Money Market in 1873 to make the case that governments or their central banks could, from time to time, stop panic in its tracks when it arose by the simply expedient of being willing to suspend the normal rules and make more money available to those who wanted it.

To halt a “run,” explained Bagehot, whether on a bank, a stock market or, for that matter, on paper claims to wheat, coal, land or any other set of illiquid assets, all that was necessary was that, in moments of acute distress, the government should ease up on its monetary policy and indicate its willingness to lend money to those who wanted cash. Not just anybody, of course; sound collateral would be required. Not too easily available, either; the government would want to charge something more than was taken to be the going rate. Above all, not too frequently; a market that expects to be bailed out by a lender of last resort may take unwarranted risks.

“Lend freely but at a penalty” became the mantra of the Bank of England in response to crises, and crises quickly eased up. Bagehot’s book was so persuasive to practitioners and theorists alike that it was credited with halting panics for a hundred years – with the single exception of the Great Depression (in which contractionary monetary policy came to seem even more important than nations’ unwillingness to lend to one another.) No one familiar with “lender of last resort” and the multifarious inventive forms that successful interventions have taken in the past could have been surprised when the response to last October’s crisis suddenly produced a bevy of new terms such as TARP, TALF and P-PIP.

Ma’am, I will come to the point. In Manias, Panics and Crashes, Kindleberger brought Bagehot up to date (though he was much too modest to say so). Able to read five languages, he took a narrative approach. He started with the South Sea and Mississippi bubbles of 1720. He worked his way forward through the innumerable crises of the Napoleonic Wars and the globalization and industrial build-out of the nineteenth century. For a second edition, he added the German Wipper-und-Kipperzeit and Dutch Tulip mania on the eve of the Thirty Years War in the early seventeenth century. Now he had more than thirty cases of speculative mania giving way to crisis, involving all kinds of instruments – British Government debt; joint stock companies; import commodities; country banks; canals; export goods; foreign bonds; foreign mines; building sites; agricultural land; public lands; railroad shares; bank shares; discount house shares; initial public offerings; mergers; copper; gold; foreign exchange; new industries; buildings; commodity futures. In subsequent editions, his schema was summarized in a table, “A Stylized Outline of Financial Crises, 1618-1990.” How much of a surprise can it be that subprime mortgages and collateralized debt obligations will now be added to the list?

Kindleberger didn’t merely make a list. Instead he described the anatomy of a typical crisis in considerable detail: the origin of speculative manias; the accompanying monetary expansion that fuels the flames; the emergence of swindles; the critical stage of “distress,” in which fond hopes suddenly give way to gloom; the means by which crisises are propagated, domestic and international; the inevitable argument between those who prefer letting it burn out vs. others who stress the role of the lender of last resort in preserving the stability of the system.

The real excitement for Kindleberger entered with the third edition, after a friend recommended Homer Hoyt’s long-neglected study of One Hundred Years of Land Values in Chicago, five cycles of real estate boom and bust. Land prices climb with share prices during a boom, Hoyt showed, but they sometimes continue to rise and then take much longer to fall after a crash, because real estate speculators inevitably think they can wait for a recovery which then doesn’t come. Commercial real estate in the US, fueled by a binge of lending by savings and loan associations, was a special casualty after the stock market crash of October 19, 1987 – but only with a three-year delay. The Japanese stock market crash in 1990 produced a downturn in Japanese real estate values that lasted the rest of the decade,.

It has not been easy for technical economists to come to grips with the propensity to crisis in the world economy. They have been more accustomed to dealing with problems of inflation, unemployment and the business cycle. When Martin Feldstein convened a conference in 1989 to discuss the reaction of regulators, policy makers, investment managers and economists to Kindleberger’s book, later published as The Risk of Economic Crisis, he said as much. The centerpiece of that volume was an essay, prescient in many ways, by Lawrence Summers on the vulnerability of the economy itself to panic in the financial sphere. Innovation had made bubbles more likely than in the past, Summers said; automatic stabilizers such as unemployment insurance, and various federal tax and spending programs made them less likely to spread to the real economy. Still, some institutions had become too large to fail, and whatever the risks might be of encouraging reckless behavior, the costs of bailing them out were small compared to benefit of protecting the real economy from a long and deep recession. These are precisely the issues with which a multinational cast of central bankers, treasury officials and policy advisers led by Summers himself are wrestling this weekend in Jackson Hole this weekend, and it is no small irony that Summers himself was not only present at the creation of the most recent wave of bubbles (as a member of the so-called “Committee to Save the World” while serving the Clinton Treasury Department) and among the most prominent victims of its collapse (as a former president of Harvard University).

Is it fair, then, to say that the present crises was seen coming a dozen years ago by a man who died in 2003? Kindleberger was no Nostradamus. He had nothing to say about the timing of the next crisis, or about how political leaders and their lieutenants would respond to it when it arrived. But he most certainly did lay out a warning that a credit crunch was on its way. And while it is true that several prominent economists saw pieces of the looming panic and crash, none but Kindleberger spelled out with such clarity the overall pattern it would take, especially the emphasis on the role of governments as lenders of the last resort. It is no accident that that the Bank for International Settlements, the central bankers’ central bank, in Basle, Switzerland, where Kindleberger once worked, and where his advice remained highly valued, issued repeated warnings that a crisis was in the offing.

(Robert Aliber, a friend who took over the preparation of new editions for Kindleberger, is himself the author of a long-running best-seller, The New International Money Game, and emeritus professor at the Booth Graduate School of Business of the University of Chicago. With the great advantage of a longer historical perspective, he has restated some of the contemporary material since the mid-’70s, showing that recent bubbles have come in waves, that four or five or more countries involved in each, and that the crises that follow when a wave of bubbles implodes set the foundation for the next wave. Most of the countries that have experienced bubbles have experienced capital inflows, he notes. “Charlie would have loved it, since the exchange rate mechanism is an important part of most of the bubbles. The aggressively-priced sixth edition [$34.95!] is due out in January.)

Meanwhile, Ma’am, the economics profession is gradually becoming more confident, despite embarrassments like the recent crisis. Your day dedicating LSE’s New Research Building – the occasion for your question – was well-spent. In time, new high-tech horizon-scanning instruments will be developed, there and in the many other research centers like it around the world, which will be more dependable for gauging conditions in the global economy than the old literary, seat-of-the-pants methods. New findings mean less need to depend on old books, at least among experts. Bagehot, when he wrote Lombard Street, had little more to go on than word-of-mouth among his own City contacts. Kindleberger had to read deeply in the English, German and French literature in order to assemble Manias, Panics, and Crashes. A new study, This Time Is Different: Eight Centuries of Financial Folly, by Carmen Reinhart, of the University of Maryland, and Kenneth Rogoff, of Harvard University, will appear in November, the first truly quantitative study of financial crises, with a special emphasis on sovereign defaults. And, of course, theorists continue to experiment with new models. With luck, the lessons learned will lead to the same sort of calmer times, at least relative to what went on before, as followed Bagehot’s landmark book. Until these are available, however, and well and truly tested, we may hope that there will be two parallel systems of supervision and control: one based on the best analysis that technical economists can devise, the other on the somewhat different tradition of central banking and regulatory authority.

In any event, since it is unlikely that we have seen the last of financial crises altogether. Kindleberger’s book is precisely the horizon-scanning device desired by thoughtful persons, monarchs and commoners alike, so as not to be taken unaware and uncomprehending by the next financial crisis. Therefore, I have taken the liberty of asking Amazon.co.uk to send the present edition of Manias, Panics, and Crashes to Balmoral Castle so that you, at least, need never ask your question again. In this I am your humble and obedient servant.

David Warsh