Why Are Financial Crashes Occurring More and More Frequently?

by Neil Chhabda



Panicking traders
(Daily Telegraph)



In 1999, in The Return of Depression Economics, Paul Krugman surveyed the economic crises that had swept across Asia and Latin America, and pointed out that those crises were a warning for all of us: like diseases that have become resistant to antibiotics, the economic diseases that caused the Great Depression were making a comeback. In this new, greatly updated edition of The Return of Depression Economics, Krugman describes how the failure of regulation to keep pace with an increasingly out-of-control financial system set the United States, and the world as a whole, up for the greatest financial crisis since the 1930s. He also lays out the steps that must be taken to contain the crisis, and turn around a world economy sliding into a deep recession.

Through Krugman’s writing of various financial crises one frightening conclusion can be made. For some inexplicable reason, financial crashes are occurring more frequently as time goes on. Even more worrying is the fact that each crash is more vicious than the previous one. In the Great Depression of the 1930s, John Maynard Keynes is famously quoted as saying, “We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand." In our modern era, it seems that the machine is much larger, substantially more delicate, and we still don’t understand how it works.



Paul Krugman: predicting a financial deluge



Another one of the alarming conclusions that Krugman arrives at is that recessions can occur at any time, even when an economy appears to be well structured and performing well. To exemplify this point, he illustrates a babysitting group in Washington DC. In this example, many couples agreed to babysit for each other and, to make this process slick and smooth, they issued coupons: a form of baby-sitting currency. If a couple baby-sat, they'd get a coupon; if they employed a babysitter for a night, they'd pay a coupon. Sounds simple right? Far from it.

What actually happened was that couples, reluctant to miss social arrangements, were more willing to babysit on a regular night rather than go out on a regular night. The capability to attend social functions was perceived as more valuable than having a night off, and as a result everybody wanted to hoard their coupons. Essentially, there was no shortage in the supply of baby-sitters, but there was no one to baby-sit for. Consequently, the group of babysitters suffered a recession. In order to solve this problem, Krugman suggests that the value of the coupons be altered, like a central bank tinkering with a currency to stimulate an economy.

This brings me on to another disturbing deduction. When economists are presented with a problem (such as a recession), they attempt to solve it by fiddling with various factors, and end up making them more complicated. They use this method because it repeatedly works, until, abruptly, it doesn’t. One of Krugman’s specialities is recession, and in this book, he illustrates their history and their causes. He suggests they occur because people formulate “ingenious” methods to make “free” money, and nobody truly understands the magnitude of the consequences until it is far too late. As it turns out, there is no such thing as a ‘free lunch’.

In New York in 1907, people invested their money in one of two financial institutions: regulated banks, and unregulated “trusts”. This meant that trusts, such as the Knickerbocker Trust, could make risky investments, and indeed in the early years of the 20th century, these trusts paid out huge sums of money. Soon, the money in banks was more or less equal to the money in trusts. This is essentially what was, is, happening in hedge funds 100 years later, and, as Krugman writes, "eerily prefigured our current crisis". When one trust failed, lots of investors tried to pull their money out of the system at the same time. The stock market, and confidence in the economy, crumbled.

This is another frightening point. The whole edifice of capitalism is essentially based on confidence. Wealth is created because people who possess confidence expose it to risk. If others believe your confidence to be reliable and accurate, you are likely to take a small risk. However as soon as people think you are bluffing, they begin to panic, and panic will always destroy wealth faster than confidence can create it.

In this book, Krugman examines various crashes, from the "Tequila Crash" in South America in the mid-90s to the crash in Asia that happened only three of four years later. He infers that they all happen for the same reason: the banking sector exposes itself to far too much risk.  As a result, people lose confidence and, again, the panic (which sometimes isn’t even based on anything real) starts. Krugman likens this panic to a feedback loop; noise from a speaker is magnified by a microphone, which relays this noise, now much louder, back through the speaker, and so on, until it's an ear-splitting screech.

And this shriek is the sound emanating from the global economy of today. Previously, if a crash occurred, someone or something big would step in to repair the damage. In 1907, that was JP Morgan and his confederation of tremendously rich friends. After the Great Depression in the 1930s, it was World War II and its aftermath which provided employment for decades. When the economies of Argentina and Mexico collapsed, it was the USA which intervened.

So what about now? Who or what will step in to save us? Well, when this book was first published in 1999, Krugman seemed optimistic: “The quintessential economic sentence is supposed to be 'There is no free lunch '. Depression economics, however, is the study of situations where there is a free lunch, if we could only figure out how to get our hands on it." Well if one of the most revered economists in the world believes in free lunches, perhaps there is hope.

Read Paul Krugman's blog here