The Risk of Economic Crisis [1991 book]

The 1991 book "The Risk of Economic Crisis" with all-star list of contributors including Volcker, Summers, Minsky, Krugman, Samuelson, Sprague, and edited by Marty Feldstein. The following were predictions about the nature of the risk of financial and economic crises in the USA:

Could the United States again experience a financial crisis like those that so frequently disrupted the real economy before World War II? ... There is cause for concern... It is probably now easier to lever assets than ever before and the combination of reduced transactions costs and new markets in derivative securities make it easier than it has been in the past for the illusion of universal liquidity to take hold. Asset price bubbles are now as likely as they have ever been... Because the risk of a currency collapse is now greater than it was when exchange rates were fixed and the world’s capital markets are tightly interconnected, the monetary authority’s scope to act as a lender of last resort has surely been reduced...

The international dimension greatly complicates the problem of the lender of last resort. While sufficiently activist lender-of-last-resort policies can always contain a liquidity crisis, there is the risk that they will set off a currency crisis... There are two related strands in the argument that a combined liquidity-currency crisis could handcuff the monetary authority... There is the risk that the lower interest rates that are part of the response to a domestic financial crisis will bring on a currency crisis...

One possible additional instrument for the authorities in time of crisis is fiscal policy. But it is hard to see what could be accomplished beyond some stabilization if aggregate demand started to decline. Excessive deficit increases are not likely to reassure foreigners who are fleeing from dollar assets. Nor are the higher interest rates that would result likely to reduce pressure on financial institutions. Reducing the deficit in the face of a major downturn is hardly the right response to crisis either. Realistically, changes in budget policy are not likely to be made or implemented quickly enough to have an immediate impact in time of crisis.

The U.S. deficit on trade account [circa 1990] is a drain on domestic profits. Furthermore, the accumulated deficits have led to large foreign holdings of U.S. financial assets. The large U.S. government deficit in relatively prosperous times means that the deficit that is needed to sustain profits in the aftermath of even an aborted financial crisis may well be enormous. In the environment that now exists, the interventions needed to sustain the economy the next time may well be beyond the combined efforts of the Federal Reserve and the Treasury... It may well be that the next time national responses will not do, and the apt international response may require a profound restructuring of the high-saving export-based economies: containing future economic and financial crises may depend more on what Japan and Europe do than upon the Federal Reserve and the U.S. Treasury.

There are no "right" answers [to financial crises], because the general tools that one uses to deal with the crisis, particularly easing the money supply, may undermine confidence. Further, the international financial repercussions can lead to a depreciation of the dollar which feeds back to internal inflation... We are not quite Argentina, but I think the Latin American model is not irrelevant to concerns about how financial crises affect the real economy...

Let us assume that we stabilize the money supply, which is what everyone says we ought to do in response to financial pressures. The first question I have to ask is, "What money supply is being stabilized?" That question sounds very easy after a crisis but is hard to answer during one. Say that the rule is high-powered money, which is very fashionable with the Shadow Open Market Committee and many other monitors these days. By this rule, the Federal Reserve did a superb job in the Great Depression, and it is only in retrospect that one can say, “Well those dumb bunnies, why didn’t they recognize that velocity was going way off course; why didn’t they react more intelligently?”... I think it is very likely that with a severe financial crisis affecting confidence in the banking system, there would be quite different behavior between high-powered money, narrow measures of the money stock, and broad measures of the money stock...

My second question is, “Even if we could figure out exactly what money supply was right, does that solve the problem?" I think what Larry Summers’s paper said was that the amount of money needed to provide reassurance and to properly reduce real interest rates may be too much not only to stabilize the currency externally but to stabilize prices internally...

Charles P Kindleberger, International (and Interregional) Aspects of Financial Crises

As therapy for financial crises, last-resort lending has the difficulties of moral hazard on the one hand and liquidation of the acquired assets on the other. There is a third possibility: that the function will get caught up in politics and thereby be prevented from effecting the necessary and salubrious work of rescue... In the series of financial crises since 1979, this country and the world have been fortunate in that the lender-of-last-resort process has escaped being caught up in political disputes. At the domestic level, some of these escapes have been narrow.

Internationally, while the U.S. role as leader of the world economy has slipped, there is no challenger that refuses to cooperate in crisis management or offers competing solutions that might stalemate decision. If a new economic world leader is called for in the interest of stability and the United States tries to hold on to its position as number one, the transition may give rise to difficulty as occurred in the 1930s when Britain proved unable to provide stability and the United States was unwilling to.

A contagion crisis happens when a financial crash in one country-typically a stock crash-precipitates financial crashes in other countries as well, generating a worldwide recession.... The macroeconomics of currency crises and contagion crises are quite different-while both can lead to recession, currency crises are usually associated with inflation in the victims, while contagion crises are associated with worldwide deflation...

Of particular concern in the present environment is the possibility that the destabilizing effects of financial crisis may catch us by surprise because they take place through international channels. It is often asserted that today’s international markets are integrated to an unprecedented degree, thanks to modem communications and information processing. There is room for doubt on this score: both international goods and international financial markets were already highly integrated by the late nineteenth century... International markets are more integrated now than at any time since the early 1930s-an observation that can be seen as ominous...

Influential commentators on the Great Depression, Charles Kindleberger most prominent among them, have long argued that the roots of the Depression lay largely in a collapse of the international financial system. They also argue that this collapse was due in large part to the absence of leadership, in particular to the failure of any one player to act as lender of last resort. In turn, the absence of leadership may be attributed to the transitional state of the international system: Britain, in relative decline, was no longer prepared to act as guarantor of the system, while the United States was still too immature to take on its appropriate role. The parallels with our own time are there if one wants to see them...

The sustainability argument says that at some point, perhaps when the accumulation of debt has risen sufficiently to draw attention to itself, the market notices that the exchange rate is unsustainable, and there is a crash... The U.S. success so far [circa 1990] in avoiding a hard landing is partly due to the fact that financial markets have not actually forced a large adjustment of the U.S. current account. If they did, the inflationary consequences of the required exchange rate change would be much larger than anything that has happened so far. If there is a type of international financial crisis to worry about, it is probably a currency crisis - the United States as a giant Latin-style debtor - rather than a replay of 1929...

What’s kind of annoying is, when people say “I PREDICTED A RECESSION 10 YEARS AGO” is whenever you predict an economic downturn (or uptick) you will always be right. Eventually.

The issue isn’t that they predicted a recession would happen enventually, as you said anyone can say that. Or even that they predict a financial crisis, which again just about anyone can do.

The issue is that they describe in 1991, long before Clinton or Obama, the vey problems - mostly international in nature - that haunt our recovery efforts today.

A lot of people on that list and in Obama’s administration had a hand in causing this crisis. There are five banks causing this mess with their toxic derivatives. These five banks hold 96% of all derivatives. They are, JP Morgan $88 trillion, Bank Of America $38 trillion, Citibank $32 trillion, Goldman Sachs $30 trillion and Wells Fargo $5 trillion. Clinton signed a bill in 2000 that let these banks create a $200 trillion dollar market that is unregulated and full of risk.

Actually the amount of underwater derivatives is $1200 trillion and they are on the books of virtually every financial institution in the world, thank you AIG. Even non-financial entities have large amounts on their books. Part of the problem is that these derivatives are non-standard contracts that were made privately and no one has any idea where they are and how much they are worth. There is no clearinghouse for them. It is a scary scenario that often has Tiny Timmy and chopper Ben holding their breath. So far the Fed has printed up or guaranteed 11 billion worth or less than one percent. Eventually this game of musical chairs is going to stop and no one is going to be left sitting or standing. Every country is holding this stuff and when it blows up no one will currency will be worth a royal sovereign.

It looks more and more like the doom-mongers are right - the scope of the problem is too big to “fix” via monetary or fiscal measures without upturning the global financial order that has existed for 35 years - long enough for everyone to take for granted, yet not long enough for anyone to completely understand.

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