(An excerpt from the new book Boom and Bust written by Alex Pollock)
“About every ten years, we have the biggest crisis in 50 years.”
—Paul Volcker, Former Chairman of the Federal Reserve
Financial crises keep happening. The economic historian Charles Kindleberger, surveying three centuries of financial history, concluded that there has been a crisis about every ten years—the same estimate given by Paul Volcker. “Kindleberger identified no fewer than thirty major financial crises in various countries between 1720 and 1990.”
More recently, the International Monetary Fund identified 88 banking crises in numerous countries around the world during the last four decades. Of course, crises often occur in multiple countries at the same time. In a 2009 book, Carmen Reinhart and Kenneth Rogoff list 320 defaults by governments on their debt since 1800. Their compilation of banking crises in countries ranging from Albania to Zimbabwe is forty-five pages long.
My own banking career began during the “credit crunch” of 1969. This was followed in 1970 by the bankruptcy of the giant Penn Central railroad—a “systemically important” railroad—which triggered panic in the commercial debt market, which, in turn, was bailed out by the Federal Reserve. The Penn Central railroad was then nationalized.
In 1974 and 1975, a massive real estate bust occurred. About two-thirds of bank loans to real estate investment trusts—the enthusiasm of the day—were nonperforming (that is, borrowers could not make their loan payments). The Senate Banking Committee held hearings on what then-chairman William Proxmire called the “inordinate risk to the banking system.” Indeed, had banks been forced to write down their loans (that is, formally account for those loans’ reduced value) to what they could be sold for in the debt market at that point, the entire banking system probably would have become insolvent.
Less than a decade later, the series of crises that marked the 1980s began with the default of Mexico on its foreign debt in 1982, which spread to a global crisis in loans to developing countries. The 1980s also included the collapse of the highly regulated savings and loan industry (financial institutions that specialize in home mortgage loans), which had a taxpayer bailout costing about $150 billion. Then there was another terrific commercial real estate bust, and the failure of more than 1,400 highly regulated commercial banks in the decade, not to mention the government bailout of the Farm Credit System.
Adding together the U.S. commercial banks and the savings and loans, more than 2,200 failed between 1982 and 1992. Citibank—a huge and famous bank then as now—was in deep trouble, and it was not alone. The headline “Banks Entering Era of Painful Change—More Bailouts, Bankruptcies, Layoffs Likely,” seemingly taken from 2009, was published in July, 1991. That same month, a Wall Street author penned this remarkable line: “Lenders are unlikely to repeat their past mistakes.” But, of course, they did, and generated the next crisis.
In an even longer view, the basic idea of cycles appears in the book of Genesis, Chapter 41. This is Pharaoh’s dream of the seven fat cows and the seven lean cows, which Joseph rightly interprets as seven good years followed by seven bad years.
What is the lesson? Financial cycles inevitably accompany economic life. But so does the continued upward progress of living standards and national wealth in a market economy. Notwithstanding numerous financial crises, people today live better than their parents, far better than their grandparents, and vastly better than their more distant ancestors. They live longer, are healthier, eat better, are better educated, work in less dangerous and arduous jobs, more easily afford basic necessities, and have more choices and wider horizons.
As Warren Buffet, the best-known investor of our time, wrote about the most recent crisis:
Never forget that our country has faced far worse travails in the past. In the 20th century alone, we dealt with two great wars…a dozen or so panics and recession; virulent inflation which led to a 21½% prime rate in 1980; and the Great Depression of the 1930s…. In the face of these obstacles—and many others—the real standard of living for Americans improved nearly seven-fold during the 1900s.
In other words, on average over time, the trend is for greater and greater overall economic well-being. While bubbles and crises continue, we cycle around a rising trend. This is because free markets release the energy of enterprise, entrepreneurship, application of new knowledge, and investment in new and better products and ways of producing them.
However, the energy of innovation is also disruptive. Over time, the economic well-being of average people keeps increasing in a most remarkable way, but we also have cycles and crises. The long-term trend is the good news. In a celebrated phrase of his great 1776 book, The Wealth of Nations, Adam Smith called this trend of increasing economic well-being “the natural progress of opulence.” Can we have the wonderful trend without the cycles? No, we can’t. The next section explains why.