On Instability
4. Assuming the IMF forecast will be borne out by the facts of 2009-2010, the present contraction can be statistically inscribed in the “map” of the crises which punctuated the last two hundred years.
The “map” is, unfortunately, very rich and extremely varied.
Nowadays, the countries adopting the market system are a bit less than 200. Few of these economies, if any, have not experienced crises in their history. This common destiny contrasts with their profound structural differences. Several economies have gone through more than one episode of severe financial and real instability. For instance Italy, wars apart, has suffered six serious contractions since its political unification in 1861: in 1873, 1889, 1921, 1929, 1992, and in 2009 (-5% in GDP).
Consequently, we can estimate an order of magnitude of several hundred crises of individual economies during the last two centuries.
Apart from war periods, the heaviest real, monetary and financial crises which can be labeled “international” – if not “global” – since they hit many economies at the same time have been at least four: 1833-1842, the 1870s, 1929-33, and the present day. The 2009 crisis looks less severe in terms of GNP contraction and price deflation, and similar as to the fall of the stock exchanges. At the same time, possibly it involves bigger in terms of the losses suffered by banks and financial intermediaries. In 1929-32 world GDP fell by 17%, wholesale price deflation reached 40%, bank losses amounted to 5% of GDP in the U.S., 9% in Austria, 10% in Italy, but did not reach, overall, the 4% of world GDP estimated by IMF in the present crisis.
1847-48 and 1973-75 were two other phases of serious and quite widespread real and financial instability.
Indeed, in the heaviest episodes instability in the real sector of the economy coincided, and interacted, with monetary and financial instability. The contraction of aggregate demand and sales determined negative profits, shrinking cash-flows, and bankruptcies of non financial firms, which met increasing difficulties in servicing their debts vis a vis creditors. The latter, in turn, plunged into non performing loans, illiquidity, losses, negative net worth, failures. The vicious circle was aggravated when price deflation, and deflationary expectations, raised real interest rates (Fisher) and the increase of the cost of capital was exacerbated by the fall of stock prices. Credit crunch, higher interest rates, pessimism reduced the capacity and propensity to invest of non-financial firms, renewing the recessionary spiral.
Not surprisingly, deep contractions in demand and production have been always associated – not only correlated – with financial instability. The contrary, however, is not always true. In a number of cases, a financial crisis has been stopped, or simply endogenously ended, before evolving into a “real” crisis. This is of special interest in the light of the present recession, which was instead ignited by financial turmoil, especially in the U.S.
I will quote three cases of crisis “abortion”, i.e. of financial crises not generating a “real” contraction: the first two – 200 years apart – were halted by public intervention, the third autonomously lost momentum without provoking a recession in economic activity.
In 1793, at the dawn of modern capitalism, the first serious financial crisis hit the City. Rumours stemming from difficulties of the British country banks caused a drain of liquidity that extended to London, where the demand for money soared. Nonetheless, the chain of bank failures was broken, and confidence restored, by an orientation of monetary policy made public by the Exchequer. In the words of a brilliant observer and protagonist – Henry Thornton – “The very expectation of a supply of exchequer bills, that is, of a supply of an article which almost any trader might obtain, and which it was known that he might then sell, and thus turn into bank notes, and after turning into bank notes might also convert into guineas, created an idea of general solvency.” (p. 50).
In October 1987 a rise of short and long term interest rates was followed by a 25% fall of Wall Street – a record decline in two days, even worse than the one in October 1929 – with contagion spreading rapidly to the major stock exchanges in other countries. The crash was halted by the immediate reversal of monetary policy, from restrictive to expansionary, enacted by the Fed headed by Alan Greenspan. In this occasion, as well as in several others during his Chairmanship of the Board of Governors – the Mexican, Asian, Russian, LTCM crises in the 1990’s – Greenspan succeeded in restoring confidence in financial and exchange rates markets, avoiding negative spillovers on real economic activity.
The third case is 1857. In that year a serious, fully fledged financial crisis started in the U.S. (railway securities), and spread to London (with the Bank Act suspended), Frankfurt, Paris. Nonetheless, both in the U.S. and in Europe real GDP did not fall.
5. The variety of forms and features which crises have assumed in history goes beyond the link between their real and financial dimensions.
Among other aspects, each crisis is unique in the main object of speculation and overtrading; in the incident which saps the confidence, reverses expectations and precipitates distress selling of commodities and assets; in the sequence and timing of the fall in the latter’s prices; in the international ramification of the bust.
For instance, speculation concentrated on buildings in the U.S. in 2009, country banks in England in 1793, railroad shares in Britain in 1836 and 1847 as well as in the U.S. and France in 1857, companies already listed in the stock exchange, going public, and merged in the U.S. in 1928-29, foreign exchanges in many occasions, as in Italy in 1992.
