Earlier this year on my honeymoon, I was sitting by the pool re-reading the financial history classic: “Manias, Panics and Crashes” by the legendary Charles Kindleberger. Required reading for any student of financial history (though not necessarily on one’s honeymoon), I was struck by the way many historical booms and busts tended to rhyme. And despite living in totally unchartered economic waters today, we wonder whether or not there are some lessons we can take away from what has been observed over the centuries, time and time again.
While the book is far too rich in insightful and fascinating content to do it justice in a short blog, there are a couple of sections worth repeating in full (starting on page 280 to be precise). It reads as follows:
“The financial tumult since the early 1970s resulted from the impacts of monetary shocks and credit market shocks on the direction and scope of the flows of funds across national borders. Several of the shocks were monetary and involved unanticipated changes in the rates of money supply growth and the accompanying changes in anticipated inflation rates and in interest rates. Some of these shocks involved the relaxation or elimination of financial regulations that facilitated changes in the
allocation of bank loans and the amount of credit available to specific groups of borrowers; borrowers that formerly had been penalized by regulations suddenly became attractive to the lenders. In several cases a credit shock and a monetary shock occurred at about the same time and had complementary impacts on the flow of funds across national borders.”
Monetary shocks relate to changes in the supply of money – something we know all about in the present times of quantitative easing. Credit market shocks are more nuanced. Kindleberger articulates shocks of this nature as ultimately stemming from the change in expectations of highly-indebted investors:
“The change in the mind-sets of investors from confidence to pessimism is the source of instability in the credit markets as some borrowers—individuals as well as firms—realize that their indebtedness is too large relative to their incomes. These borrowers begin to adjust to their new perceptions about the economic future by reducing their spending so they will have the cash to pay down debt or to increase saving. Some firms may sell divisions and operating units to get the cash to pay down debt. The lenders recognize that they have too many risky loans and so they seek repayment of outstanding loans from the borrowers that they deem most risky; they become reluctant to renew these loans as they mature. The lenders also raise the credit standard for new loans.”
Again, this is somewhat relatable – especially in the context of the highly-indebted world in which we find ourselves (see our recent note on the Risky Trinity for more on this topic). Kindleberger basically argues that shocks of this nature impact the flow of capital between countries. And to the recipient country of these flows, a new bubble can form. Kindleberger goes on to say:
“An increase in the flow of funds to a country induces increases in the prices of both its currency in the foreign exchange market and the securities and other assets available in the domestic market; the increases in these prices during the mania phase of the expansions caused market prices to increase above their long-run equilibrium values.”
So here we are in a world in which there is over-indebtedness in China, Japan and most of Europe. There are risks on the horizon that relate to each of these regions: deteriorating credit quality within China’s banking system assets; the prospect of Money Financed Fiscal Programs (or Helicopter Money) in Japan; or the upcoming constitutional referendum in Italy that, if lost, could see the Italian nation ultimately move to a referendum on EU membership.
Any one of these events could result in shocks of the nature that Kindleberger describes; and the consequence of such shocks could result in an overwhelming flow of funds across borders to the global safe-haven, the United States. Kindleberger’s analysis of historical manias suggests these dynamics would result in substantial increases in the US dollar, stocks, bonds and property. It is certainly a perspective worth considering. While somewhat counter-intuitive, such an outcome would certainly rhyme with our prior financial history.