China's Red Flags – March 2010
considered to have become less risky and valuationssoared. A similar argument was trotted out in themid-1990s when it was widely believed that theGreenspan Fed had succeeded in taming the businesscycle. The “New Paradigm” disappeared in the bearmarket of the new millennium. It was soon replacedwith the “Great Moderation” thesis of Ben Bernanke,which suggested that high levels of mortgage debtmade sense because monetary policymaking was sovastly improved. Alas, the Great Moderation turnedout to be yet another example of that always deludedbut oft repeated claim that “this time is different.”3.
A general increase in investment
is another leadingindicator of
nancial distress. Capital is generallymisspent during periods of euphoria. Only duringthe bust does the extent of the misallocation becomeclear. As the nineteenth century economist John Millsobserved: “Panics do not destroy capital; they merelyreveal the extent to which it has been previouslydestroyed by its betrayal in hopelessly unproductiveworks.”
During the British railway mania of the 1840s, threeseparate train lines were built between London andPeterborough. One would have suf
ced. After thetech bubble collapsed, new
ber-optic pipelinesexperienced tremendous overcapacity that lingeredfor years. A recent IMF World Economic Outlook observes that countries with a high investment shareof GDP tend to suffer the steepest and most prolongedeconomic downturns.
4. Great booms are invariably accompanied by a
As the great Victorian journalistand economist Walter Bagehot put it, “All peopleare most credulous when they are most happy; andwhen money has been made ... there is a happyopportunity for ingenious mendacity.”
The Great Crash,
John Kenneth Galbraithdescribed a cycle of fraudulent behavior, whichhe termed the
“In good times people arerelaxed, trusting, and money is plentiful. But eventhough money is plentiful, there are always manypeople who need more. Under these circumstancesthe rate of embezzlement grows, the rate of
J. Mills, “On Credit Cycles and the Origins of Commercial Panics,”
Trans- actions of the Manchester Statistical Society,
IMF World Economic Outlook, October 2009.
The Collected Works of Walter Bagehot,
discovery falls off, and the bezzle increases rapidly.”
5. Strong growth in the money supply is another robustleading indicator of
lies behind all great episodes of speculation fromthe Tulip Mania of the 1630s – which was fundedwith IOUs – onward. Low rates lead investors tochase after higher yielding and riskier investments.According to Walter Bagehot, “John Bull can standmany things, but he cannot stand two per cent.” Wheninterest rates fell to this meagre level, he commented,people were driven to “invest their careful savingsin something impossible – a canal to Kamchatka, arailway to Watchet, a plan for animating the DeadSea, a corporate for shipping skates to the TorridZone.”
Fixed currency regimes
often produce inappropriatelylow interest rates, which are liable to feed booms andend in busts. This lesson was ignored by the creatorsof the European Monetary Union, which brought lowrates and real estate booms to its smaller members,Spain and Ireland. A
xed exchange rate regime alsocontributed to the Asian crisis of 1997. Large capitalin
ows are another leading indicator of
nancialinstability.7. Crises generally follow a period of
rampant credit growth.
In the boom, liabilities are contracted thatcannot subsequently be repaid. Economists at theBank for International Settlements have shown thatsharp deviations of credit growth from past trendshave predicted
nancial crises with an 80% successrate.
A more recent academic study of numerouscredit booms over the last century and a half concludesthat “lagged credit growth turns out to be a highlysigni
cant predictor of
is another common feature of greatspeculative manias. Credit booms are often takento extremes due to a prevailing belief that theauthorities won’t let bad things happen to the
nancialsystem. Irresponsibility is condoned. During AlanGreenspan’s tenure at the Fed there was a general
The Great Crash.
The Collected Works of Walter Bagehot,
“Asset Prices, Financial and Monetary Stability, Exploring the Nexus,”Claudio Borio and Philip Lowe, BIS, July 2002.
Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and FinancialCrises, 1870-2008,” Moritz Schularick and Alan Taylor, NBER, November2009.