Looking back, it was easy to see that the crash was coming. There had been too much cheap money. Debt had exploded. Speculation was rife. The gap between rich and poor had widened. Welfare spending had risen. The financial system was so stretched that even a modest tightening of policy was enough to make it impossible for over-borrowed debtors to service their debts.
The US in 2007? No, this was imperial Rome during the reign of Tiberius in AD33. It was not the first documented financial crisis; that dubious accolade goes to the states of the Delian League in ancient Greece, which defaulted on their debts following a naval blockade by Sparta.
But a time traveller would see remarkable similarities between the unfolding of the Roman crisis of almost two millennia ago and the 2007-09 crash. The calling in of loans led to a credit crunch. Debtors went to the wall. Prices fell. The emperor arranged for the most heavily indebted to get interest-free loans for three years. A “bad bank” was set up. Tiberius financed his own version of quantitative easing, not by selling imperial bonds but by confiscating wealthy Romans’ assets
All of this is documented in an excellent new book by Bob Swarup called Money Mania*, which looks at booms, panics and busts down the ages. His message is that nothing is really new. Put together people, credit and structural fragility and you create the perfect conditions for a crisis.
Swarup’s book comes out at an opportune moment. The past week has seen a shudder pass through stock markets as investors have taken a closer look at some of the more highly valued technology stocks. Easter traditionally marks the start of the British house-buying season, and this year’s begins with sales at a six-year high and prices up almost 10% on a year ago. The appetite for risk was highlighted by the demand for the five-year bonds issued by the Greek government.
Inevitably, the talk is of bubbles about to pop, of a new speculative mania, of lessons not learnt. This talk is a bit premature but the warning signs are there.
History suggests that certain conditions have to be in place for a crisis to develop. The first is that a decent period of time has to elapse after the previous crash. When bubbles burst, a cavalier approach to risk is replaced, almost instantaneously, by risk aversion. It takes time for those burned by their losses to forget. In the UK, for example, there was a property boom in the early 1970s, another in the late 1980s and a third in the early to mid 2000s. A 15-year gap is the norm.
The second condition is a sustained period of solid growth, by the end of which individuals convince themselves that the good times will go on and on. Accordingly, the property boom of the early 1970s came after 25 years of strong growth; the overheated market in the late 1980s stemmed from a belief that Thatcher’s reforms had eradicated all the economy’s problems; that in the 2000s came amid a period of uninterrupted growth lasting more than 60 quarters.
A third crucial factor is belief in those running the show. The runup to the GreatRecession of 2007-09 was the heyday of independent central banks, which preened themselves on their ability to deliver solid non-inflationary growth. There were a few, such as Bill White at the Bank for International Settlements, who warned that bubbles could develop in low-inflationary periods, but they were ignored. The public assumed that central banks were fully in control – a misplaced confidence as it turned out.
Central banks, no matter how clever, cannot prevent crises. The establishment of the independent Bank of Amsterdam in 1609 did not prevent the tulip mania of the 1630s; the founding of the Bank of England in 1694 was followed a quarter of a century later by the South Sea Bubble. The Wall Street Crash occurred 16 years after the creation of the Federal Reserve.
Whip these three ingredients together and you have the recipe for a crisis. As Swarup notes, humans don’t like to stand still. “Growth is a strong psychological impetus, and if we are not growing in our lives in some way, we feel trapped and miserable.” So a recent period of growth plus confidence in policymakers allows us to extrapolate the past into the future, even if that means ignoring inconvenient facts.
But more is needed to create the perfect bubble dish. Crises do not occur unless there is an abundance of credit to allow debt to build up and to permit speculators to take ever bigger bets. When economies become saturated with debt, as they were in the mid-2000s, it is time to prepare for the worst.
That is certainly the case if complex financial systems are badly flawed. Nobody really understood what the web of banks, hedge funds and shadow banks were up to as they traded credit default swaps and collateralised debt obligations. Regulators certainly didn’t.
These two final ingredients matter. In the absence of credit and a functioning framework, economies grow only very slowly, as they did in the 1,000 years after the Roman empire collapsed. But too much debt plus poorly managed and regulated financial systems will, sooner or later, lead to trouble.
The fact that we are still bubble conscious suggests that the right conditions for a bubble do not yet exist. Insufficient time has passed. Investors are able to differentiate between tech companies that are not making profits and firms in the real economy that do have a track record of earnings growth.
In the UK as a whole, house prices have yet to return to their pre-crisis peak, although they have already done so in London. Regulation is still being tightened as policymakers seek to avoid the mistakes of the past. The eurozone is only just emerging from a triple-dip recession and Britain’s national output is still lower than it was six years ago. A much longer period of expansion will, on past form, be necessary for the onset of amnesia.
All that said, there are a couple of reasons to beware. One is that central banks could leave policy too loose for too long. Dario Perkins, of Lombard Street Research, is one analyst cautioning that if the Fed leaves policy as loose as forecasts suggest, it could create new asset bubbles. The other is that in the age of Facebook and Twitter, only “now” matters. If we have lost our capacity to remember, trouble may come sooner than we think.