Hubert Fromlet Professor at Jönköping International Business School (JIBS) & Linnaeus University / Sweden
Predictability of Financial Crises: Lessons from Sweden for Other Countries - China Included Paper prepared for the GIC Conference (Global Interdependence Center, Philadelphia) in Stockholm, September 29, 2011 Abstract / Summary The predictability of financial crises is widely regarded as low, particularly in academia and at central banks. This dominating belief should, however, in many cases be considered as a flight from trying to acquire improved skills – skills that are greatly linked to market psychology (behavioral finance) and the understanding of history and macrofinancial aggregates. Sure, behavioral finance has gained some reputation in the past 10 or 15 years. But its benefits are still undervalued, particularly when trying to recognize exuberant financial markets and the risk of bursting asset price bubbles at an earlier stage. The above-mentioned areas of financial markets research have been insufficiently integrated in the forecasting and risk management of financial institutions as well. It is time to accept that the neoclassical model - which still dominates financial modeling - can no longer be applied as nicely as it has in the past. It has been obviously the case in Sweden that the financial crises of the early 1990s and in the latter part of the past decade were caused by overconfidence, control illusion and flock mentality - but also by shortcomings in management and corporate governance. The first failure meant severe austerity for Swedish households, the second for the Baltic countries - particularly in Latvia. Research on the banks’ management failures remains underdeveloped. There is no evidence whatsoever that these two serious Swedish banking crises were not foreseeable. Only 17 years had passed between the eruptions of the two crises. The question is when and under which circumstances financial decision-makers and authorities should listen to the usual minority of warning voices. And how (certain) warning voices can/could be heard more effectively, both now and then. Rating institutes are obviously unable to play this role. They often make things even worse. Another important conclusion is that economists should be more “in house-oriented” and inform their top management regularly about issues that will or may affect their financial institution. Top managers, on the other hand should take the time to meet economists - and stop hiding their own frequent shortcomings in macroeconomic and macrofinancial skills. Certain conclusions from this paper can also be drawn for China, India and other emerging markets. Key words: Financial crisis, behavioral finance, forecasting, China, India, management and corporate governance JEL: C 00, E 44, E 58, G 28, G 34, G 38, N 24, O11, O12, O 53
1.Introduction and history It is widely said that each financial crisis has its own characteristics. This is true to a great extent. However, financial crises also tend to have common roots. One of them - maybe the most significant one - is the creation of credit bubbles which are frequently preceded by loose monetary policy that has occurred for too long and/or the acceptance of sustained and increasing major deficits in the current account balance. Deficits in the current deficit are by definition deficits in a nation’s savings which may originate from the private and/or the public sector. Consequently, increasing deficits in a country’s balance on current account can be derived from widening deficits/shrinking surpluses in, for example, savings of the government and/or private households. These rising deficits are also reflected in a country’s fiscal budget balance and the private savings ratio.
a) The great financial crisis of the (early) 1990s – crisis 1 From the mid 1970s when the consequences of the first big modern oil crisis were felt (OPEC I) until the mid-1990s, Sweden was characterized by significant deficits in national savings. During these two decades only a few years were noted with the current account roughly in equilibrium.1 Several devaluations took place during the latter part of the 1970s and during the 1980s, accompanied by persistent inflationary problems. A major fall in the value of the Swedish crown also occurred after the transition of the crown to a floating exchange rate regime in late 1992. The Swedish crown was during this long period kind of unilaterally fixed, against the Deutschmark and mostly vis-à-vis a trade-weighted currency index – and between June 1991 and November 1992 even visà-vis the then artificial EU-currency unit, the ECU. These were crucially negative links in times of (mostly) poor developments of the Swedish current account and the public budget. In the 1980s, the Swedish economy was in a horrible structural shape. This disaster was caused by high government expenditure, enormous wage rises and inflation, but it existed also in terms of regulations and competition, subsidies, the structure of the labor market, incentives on all levels, entrepreneurship, financial markets and the tax system. For example, marginal taxes for ordinary wage earners were as high as 60-65 percent, often even more. On the other hand, interest payments for private households were deductible in these high ranges as well. In combination with high inflation, this constellation meant, over many years, negative real interest rates for consumers and house-owners, i.e. household savers and borrowers. This situation certainly favored the creation of debt enormously - a situation that was not remedied until the implementation of a major income tax reform in 1990/1991.2 From this point onward, interest rate deductibility in the tax bill has been reduced to 30 percent. Initially, this change was received as an income shock by most Swedish households. Today, this rule still exists but households have got used to it. The initial shock from the tax reform in the early 1990s came, however, at the same time as the banking crisis was getting progressively worse. There has obviously
been no real co-ordination between different structural changes in economic policy by the public authorities involved. On the other hand, the tax reform was badly needed. Let’s also have a look at the Swedish financial market of the 1980s, i.e. the years before the eruption of the first modern domestic Swedish financial crisis. First, there was no real financial market in a broader market sense. Daily trading of government and mortgage papers did not exist to any mentionable degree. At this time, we were instead talking about a regulated credit and bond market. By law, banks also had to invest an important percentage of their deposits in government bonds and in the bonds of the mortgage institutes/banks. Insurance companies had strict investment rules that favored bonds, too, which, consequently, at the end of that financial chain put the government and the housing sector in the first investment place. Credit ceilings for the banks were considered to be a “normal” regulation. However, banks cheated a lot in this context by selling parts of their excessive new loans to insurance companies overnight just before the end of the month when the new credits were measured - and by buying these credit assets back as soon as the new month had started. Thus, the credit ceilings were formally met. Here we can observe one of the most ridiculous loopholes of the Swedish credit market that still existed in the mid-1980s. Therefore nobody was surprised when the credit ceilings of the Riksbank were finally scrapped in 1985 - to be exact on November 21 which is quite a remarkable day in Swedish economic history. From this day onward, a fast credit expansion started which ended with the bursting real estate bubble in 1990/1991. Another phenomenon has to be briefly explained in order to clarify the origins of the Swedish financial crisis of the early 1990s. Until 1989 - only just over twenty years ago – Swedes and Swedish institutions were virtually banned from investing in foreign stocks, bonds, and real estate. There were some minor exceptions, but these were not of any economic significance. Suddenly, these cross-border activities were made possible. This happened in a period of an ongoing fast credit expansion. This could not be regarded as an optimal timing. Large numbers of Swedish real estate investors went directly to London, Paris, Amsterdam, Frankfurt, etc., in order to purchase commercial real estate. This happened - as can easily be concluded from this brief historical description - without any experience of foreign real estate markets. Flock mentality was booming. In the early 1990s, I actually heard many comments by colleagues in London, Frankfurt, etc., that the Swedes were paying “any price” to enter local commercial real estate markets in continental Europe and Britain. Obviously, some kind of irrational exuberance could be noted. Thus, the new financial structure looked - in a partial perspective - as follows in the year 1990: ¤ the credit ceiling for the Swedish banks had been abolished a couple of years before; ¤ high liquidity ratios for compulsory purchase of government and mortgage bonds had been scrapped; ¤ deductibility of interest payments for the debt of private households was reduced substantially; ¤ free cross-border financial and real estate investments for Swedish investors (but also vice versa) were created.
A big theoretical question was then how the Swedes would manage to handle this relatively abruptly won freedom of cross-border capital flows. However, nobody really tried to investigate the topic more seriously at the time. The relief after the newly-found liberty to invest abroad was so great that it was difficult to discuss, for instance, the important issue of the sequencing3 of the different financial deregulations and other structural reforms. Deregulation was treated like a “deus ex machina” in Greek mythology, i.e. as something strongly desired that suddenly showed up. Consequently, there was (almost) no time – and room - for second thoughts and criticism. The whole banking community, the government and the Riksbank had become strongly aware of the fact that the old regulations for banks, insurance companies and cross-border investors were full of loopholes. And something which should not be overlooked either - other advanced countries had already deregulated their financial markets substantially. So, why on earth could anything go wrong in the Swedish deregulation process? There was actually a psychological hype going on in the second half of the 1980s that nobody cared about. Conclusion1: New structural conditions on deregulated financial markets that lead to euphoria may end in overconfidence, control illusion and financial bubbles. This is shown by the Swedish examples. Psychological studies and observations of the players on the affected markets should be logical. In growth terms, the above-mentioned first major financial crisis was very costly. GDP fell three years in a row between 1991 and 1993, altogether by 5 percent. Consumers were squeezed by the government’s austerity packages. The open unemployment rate rose from 1.6 to 8.2 percent in the first years of the 1990s. On the other hand, two ruling governments during the crisis - one non-socialist and one socialist - succeeded in making the public sector much more effective. Furthermore, subsidies were reduced substantially. These two latter achievements are often underestimated in the public debate, even though they contributed substantially to the large improvement of the public financial situation. But Sweden was lucky as well. At approximately the same time as the beginning of the very severe Swedish financial crisis was noted , the U.S. started its positive performance in the 1990s, and Europe was positively affected by the German unification boom. This all happened when the Swedish crown started to float down to much weaker levels than noted during the period of the (unilaterally) link to the ECU. Swedish export companies were stimulated enormously by the sizable depreciation of the crown which meant a remarkable recovery on the stock exchange as well. Despite a continuously weak domestic demand in the economy (private consumption, construction) and very serious unemployment problems, confidence gradually increased in Swedish corporate rooms and private homes. Altogether, also the recovery of the Swedish economy had its pain. It took several more years from the turning point to bring down total unemployment more substantially. Unfortunately, youth unemployment remains on very high levels ever since these bad days, i.e. at about 20 percent, among the highest rates in the whole EU area. This may well be the main failure in economic policy during the past two decades and should not be overlooked, despite all the positive developments when it comes to
inflation, government finance, the current account, competitiveness, the pension system, entrepreneurial spirit, innovation capacity, etc. Conclusion 2: The timing of economic policy measures affecting financial markets may be very important. Sometimes flexibility is needed even in this respect. Too many major structural changes to the financial markets within a short period of time may have counteracting effects. The issue of sequencing may be crucial.
b) The second (limited or almost) crisis of the year 2000 – crisis 2 There is not so much to write about this event, which was nothing else than part of the well-known global IT crisis from the beginning of this millennium. This disappointment turned out to be a crisis where stockowners were hit - but hardly Swedish banks. The Stockholm Stock Exchange went down by more than 70 percent in the following three years as a consequence of the global and Swedish IT hype. However, one big question was never really elaborated on: Why did so many financial executives, asset managers, economists and journalists have such short memories considering that substantial financial exuberance had taken place in Sweden only ten short years earlier? In early 2000, quite a number of listed IT companies had p/e ratios exceeding several hundred - more or less without major shouting from financial analysts. One reason for the relative silence may have been that many younger analysts or financial advisors had been fired during crisis 1 in the first half of the 1990s due to what were at the time far too strict Swedish labor laws. This meant that a large number of relatively recently employed young people - without experience from the past crisis - were not able to interpret the exuberance of IT stocks appropriately. And more experienced financial officers may have been too ambitious in selling stocks - plus that Sweden was part of the global IT overconfidence. Conclusion 3: Previous exuberance on the financial market is not always remembered very well, even if the latest bursting bubble occurred more recently. This phenomenon is striking. It remains to be seen whether new and better experiences and conclusions from history can be made in the future once global financial markets have been brought back on more solid ground in the aftermath of the current global crisis.
c) The third (almost big) crisis of 2008/2009 – crisis 3 I continue to argue that crisis 3 of mainly 2008 and 2009 was the most avoidable of the three that are mentioned in this paper. Some Swedish banks made during the 1990s strategically very logical and farreaching investments in the Estonian, Latvian and Lithuanian banking systems. One could say that the Baltic banking system was clearly dominated by two Swedish banks, Swedbank and SEB. Already in the 1990s, some banking problems showed up in the Baltic states, although they did not cause any major macrofinancial and macroeconomic problems at the time. In the beginning of the past decade, financial structures and solidity seemed to be at healthy levels. The two Swedish banks made a
lot of money. But a very unhealthy credit boom was started and accelerated while macroeconomic fundamentals simultaneously worsened - without intervention by the supervisory and fiscal authorities in the three Baltic states. Very importantly, monetary policy was no longer a tool to cool down the ongoing credit boom. The reason for this inefficiency was Estonia’s, Latvia’s and Lithuania’s unilateral but formal link to the euro by joining the European Exchange Rate Mechanism 2 (ERM 2) with more or less fixed rates against the euro. This currency regime meant that monetary policy had to target the exchange rate - and not inflation, credit growth and, consequently, domestic financial stability. Conclusion 4: (Almost) fixed exchange rates tend to worsen major competitive/current account imbalances.
Two main indicators reflecting the credit bubble in the three Baltic countries Credit growth (%, in real terms)
Estonia
Latvia
Lithuania
2004:
27
26
39
2005:
28
49
60
2006:
36
28
49
2007:
26
31
26
2008:
-3
3
- 1
2009:
-5
-11
-19
2010:
-7
-2
- 9
2004:
- 10.6
- 12.9
- 7.7
2005:
- 9.4
- 12.6
- 7.1
2006:
- 13.9
- 22.6
- 10.6
2007:
- 14.6
- 22.4
- 14.5
2008:
- 9.3
-13.1
- 13.1
2009:
+ 3.9
+ 8.6
+ 4.3
2010:
+ 3.9
+ 3.0
+ 1.8
Current account deficits (% of GDP)
Source: Reuters Ecowin, Swedbank
Surprised that the credit bubble finally burst - and that the recently improved current account balances can be related to the effects of austerity and weakened imports? And what happens in a few of years?
2. Theoretical background and research The ambition to look somewhat deeper into financial crises can be supported by a lot of research. In the Swedish cases, the following theoretical or research angles fit particularly well. These are: ¤ economic history ¤ institutional economics ¤ behavioral finance ¤ finance/financial markets and economic growth ¤ human capital/education on a managerial level and economic growth/economic recession ¤ simple/well-established macroeconomic fundamentals.
¤ Economic history There is a saying that each financial crisis has its own characteristics. This is partly true - but only partly. Most domestically originated financial crises actually have common roots: loose monetary policy, an irresponsible credit boom and exuberance on the real estate market. Charles Kindleberger published the first edition of his masterpiece “Manias, Panics, and Crashes” as early as 1978.4 Henry Kaufman, legendary former chief economist at Wall street - probably the most powerful chief economist ever and later on professor, wrote, for example, in 1983: “Regulation of money is as old as the U.S. Constitution. The push to deregulate financial institutions is new and poses dangers. Some re-regulation is unavoidable.” 5 The Swedish example: Financial exuberance was not a hot topic in research and analysis in the 1980s. A number of smart economists, however, observed developments on deregulated financial markets very carefully, particularly in the U.S. Sweden was almost completely absent in this context. The only high-level expert who already around 1987/1988 loudly warned of a forthcoming financial crisis because of the financial expansion was according to my knowledge Sören Andersson, at the time EVP at Swedbank. Andersson based his conclusions to a large extent on historical studies. He even published articles on this issue (e.g. in the weekly journal “Affärsvärlden”).
¤ Institutional economics Research by Douglass North, Gordon Tullock, Anne Kreuger, very recently by Dani Rodrick6 and many others shows very clearly that well-functioning institutions are crucial to the economic development of a country. So is the avoidance of rent seeking. When it comes to financial crises, institutional
shortcomings and/or failures are often linked to insufficient financial supervision and central banks that have not really met their mandates. The Swedish examples: Considerable failures in supervision could be found in crises 1 and 3. Before crisis 1 started around two decades ago, the supervision authorities were in uncharted waters after major deregulations of financial markets and other structural economic policy reforms. But this is no real excuse. Swedish supervisors should have been even more vigilant because of the new financial conditions that were created at that time. Crisis 3, on the other hand, was a financial crisis in the Baltic countries - but it also had deep roots in poor Swedish risk management - public supervision and financial stability institutions included. Neither the Swedish Financial Supervisory Authority nor the central bank (Riksbank) recognized the real seriousness of the rapidly deteriorating current account balance in the three Baltic states. Sure, the Riksbank had some warnings in its stability reports. But the Riksbank’s mandate of maintaining financial stability was not met. An institutional failure par excellence!
¤ Behavioral finance During the period of the major Swedish financial deregulation in latter part of the 1980s, behavioral researchers like Kahneman, Tversky, Thaler and Shiller were just about to publish important papers on psychological behavior which also included reactions in financial markets. However, there was no broader scientific recognition of behavioral finance at that time. Such a new form of psychological input in economic and financial studies should at least be taken more seriously in the aftermath of the subprime crisis and the European turmoil with all its psychological overdoing. But not very much has happened so far. The conservative modeling approaches still defend their dominating position quite easily. Even central banks remain reluctant to attempts to use behavioral finance in their research, probably due to the well-known difficulties of expressing behavior mathematically. But how can progress be achieved without trying seriously for quite some time? Obviously, it continues to be more comfortable for traditionalists to stick to the well-known ways of modeling, based on the “homo oeconomicus” - a simplified human being who is always provided with all necessary information for decision-making and who always acts rationally in a nice atmosphere of full transparency. Only recently we have seen - and can still see - examples where these assumptions made about the “homo oeconomicus” were simply not in place. Instead, we could/can watch important cases of psychological exuberance related to concerns in the U.S. and in the EU/EMU – and we still do. In a NABE article (National Association for Business Economics, Washington D.C.) from 20017, I made some recommendations about the contribution of behavioral finance to increasing the predictability of financial crises. In order to single out specific behavior that may have a visible impact on financial markets, one should particularly look at the potential existence of the following phenomena:
preferences for certain news, the psychology of sending messages, anchoring, representativeness by paying more attention to certain circumstances than they initially deserve, overconfidence and control illusion, and, of course, the degree of herd mentality. My own conclusion is that it should not be impossible to develop models that give information on strengthening negative trends in these mentioned psychological respects. In the years following 2001, I had a couple of meetings at Yale University with Robert Shiller who convinced me with his views and publications8 - based on psychological studies of heavily indebted U.S. households - that the U.S. was about to face serious problems a couple of years later. For my own purpose, it was really not very complicated to apply some of the popular terms of behavioral finance I summed up above related to my NABE article from 2001 when regarding the financial risks in the U.S.in the middle of the past decade and only somewhat later in the Baltic countries. The Swedish example: As has been pointed out earlier in this paper, there was absolutely no feeling for psychological overreactions after the big Swedish financial deregulation process in the second half of the 1980s. Research in this field had started to gain some momentum in the U.S. but there was no positive research contagion on Europe. In Sweden, we were then more or less sticking entirely to the messages of the homo oeconomicus, too. Before (almost) crisis 2 and crisis 3 in Sweden, however, there was already much better access to behavioral finance research in Europe as well - but too few experts were using it. I based my own warnings for a financial and GDP crash in the Baltic states during 2004/2005 again on my own already quoted NABE paper with the title “Behavioral Finance – Theory and Practical Application� . Most terms and categories of behavioral finance which I used in this article, fitted very well into this affluent period in the Baltic states, particularly Latvia. However, still not enough academics cared about behavioral finance at that point. Even the Riksbank was not very familiar with it. This was obviously a mistake. Consequently, the legal mandate of the Riksbank to maintain stability in the financial system was sharply neglected and violated. At some point particularly Swedbank was in major liquidity troubles. Fast public action, however, extinguished the already ongoing fire at an early stage.
Finance, financial markets and economic growth There is not much fundamental research on the connection between distorted or damaged financial markets and the economy as a whole, compared to the opposite approach, i.e. what well-functioning financial markets or structural improvements of financial markets mean to positive economic growth and other macroeconomic components. Schumpeter dealt with this latter issue as early as 100 years ago, by linking the financing of innovation to increased productivity and, thus, to economic growth. King and Levine took a major step to revive this approach in the 1980s. Others, such as Lucas, found the role of financial markets to be overstated in relation to the real economy.
A positive correlation between financial and economic development is nowadays widely accepted, but not necessarily the causation. In my opinion, skeptics could also get or take intellectual support from Hyman Minsky. Minsky emphasized - especially in the 1970s and 1980s - the macroeconomic risks that come from asset price bubbles and other financial exuberance. After first being an outsider, Minsky gained a lot of re-consideration during the subprime crisis of 2007-2008 and the contagion on the real global economy that followed - with recessions in many developed countries. The Swedish example: Certain academics may have their doubts about the correlation between financial markets and economic growth - or rather about causality. Reality, however, allows for clarifying conclusions. Sweden had a very disastrous debt accumulation in the latter part of the 1980s. The same experience could be made on crisis 3 when the three Baltic states were misguidedly led into a credit bubble by some shortsighted Swedish banks and reluctant supervision authorities at home and in Sweden. As we all know, very negative consequences could be summed up later on. In conclusion, one may say that the “Minsky moment” could be observed twice in the past twenty years in the Swedish economy. This is quite a lot.
¤ Human capital/education on a managerial level and economic growth There exists a lot of research on the positive impact of human capital/education on economic growth (Becker, Lucas, Barro, Murphy K., Romer P., etc.), both from macroeconomic and microeconomic angles. However, little research can be found about the reverse perspective, i.e. the macroeconomic risks that can be derived from insufficient education, skills or updating on a managerial level. The Swedish example: Crisis 1 was to a great extent caused by new conditions on financial markets and, thus, could not easily be foreseen by financial managers – though it would not have been impossible for psychologically and historically interested or skilled financial leaders. Crisis 2 also had managerial shortcomings since very high price/earning ratios were not alarming enough to wake up financial leaders. Crisis 3, however, demonstrated very nicely how shortcomings in fundamental macroeconomic skills on executive bank levels finally led to tragic economic developments in the Baltic countries, particularly in Latvia.
¤ Simple macroeconomic fundamentals This example is linked to the previous one. Despite many new conditions and formal/informal rules on global financial markets, there are still macroeconomic fundamentals and old “rules” that never should be forgotten or neglected. The legendary business economist Walter Hoadley9 wrote in 1996: “Probably the most striking challenge confronting the profession [of an economist, own note] is the too common attitude among corporate executive officers that the economics they learned for their MBA degrees is essentially all they need for life”. This insufficient behavior or reaction - which actually also can be regarded as a shortcoming in corporate governance - could really be observed in recent years.
Things get worse, for example, when too many corporate/financial executives and other important managers do not even understand or do not want to understand the contents of a current account balance and the financing of its deficits via the capital balance. This happened partly in Sweden in crisis 3. In other words: macroeconomic fundamentals concerning, for example, the current account, public domestic debt, foreign debt, inflation, expansion of money supply and credits, etc., should never be neglected when trends become increasingly worrisome. They may affect the financial sector later on. The Swedish example: Crisis 3 is particularly representative when it comes to insufficient management skills and corporate governance. Too many financial executives, leaders of supervisory authorities, and journalists chose to ignore the rapidly increasing current account deficits in all three Baltic states. However, in certain cases, clear distinctions between insufficient skills and personal greed/pressure from shareholders could not be drawn. More research on this topic could be interesting. Conclusion 5 : Altogether, theory and research give a lot of applicable results and hints for analysts who want to find ways to increase the predictability of financial crises that can be picked from academia - though not in a comprehensive model.
3. Predictability of the first modern Swedish financial crisis In the context of this paper, a financial crisis is not equated with a currency crisis. Pure currency crises that were caused by an overvalued Swedish currency and that led to some official devaluations actually occurred a couple of times in the latter part of the 1970s and during the 1980s. But they never formed a direct major systemic threat to the Swedish banking system. The unilateral links of the Swedish crown to certain trade-weighted currency baskets simply did not draw enough (foreign) attention to Swedish financial institutions in our - then - much less globalized financial world. However, conditions changed in the early 1990s when the first major post-war Swedish financial crisis (crisis 1) started. As already mentioned, remaining regulations in the Swedish financial system - i.e. restrictions on cross-border transactions - were completely abandoned in 1989. Sweden also became analytically much more closely integrated in the global financial market system - but still not so much in the end of 1990 when the credit bubble started to burst. Thus, the environment of deregulation from November 1985 to the fall of 1990 was analytically almost exclusively in Swedish hands. There were many signals that gave reason for concern, as mentioned before, but (almost) no one wanted to interpret or react on the psychological overreactions. I remember very well an article that I sent in 1988 or 1989 to a major Swedish newspaper about the accelerating financial risks in Sweden. This article was rejected with the motivation that the gloomy projections made in my article were really not suitable for publication when the economy was improving so nicely.
Somewhat later I sent the article in a somewhat softer version to the monthly journal of my banking group. They printed this contribution. But I was confronted with another surprise. A number of credit officers called me with obvious irritation and sent clear warnings to me that they did not want me to get involved with what they called “their nicely expanding credit business�. These two personal anecdotes probably say enough about the possibilities of giving warning signals to the important decision-makers before the eruption of the first great post-war banking crisis in Sweden. Predictability was not totally bad. But the opportunity to send the warning messages to the right people was too limited.
4. Predictability of the second modern Swedish financial (almost) crisis In the 1990s, Sweden managed to establish a considerable IT industry and succeeded at the same time in gaining a global top position when it came to the relative number of internet users. Successful IT entrepreneurs were glorified in most media. Opportunities seemed to be unlimited and were quite strongly driven by fantasy. As described before, crisis 2 never became a banking crisis, even though many shareholders were strongly hit. However, all the extremely high p/e ratios for many IT companies should have been noticed by Swedish financial executives/managers and financial analysts much more carefully than has been the case. But we should keep in mind that the IT crisis was not just a Swedish phenomenon. It was also a global one.
5. Predictability of the third modern Swedish/first Baltic financial crisis I would argue once more that the deep economic and financial crisis in the three Baltic states was the most predictable one, and was - at least partly - caused by Swedish analysis and policy mistakes, both in the private and the public financial sector. The warning signals were very obvious, both for the Swedish banks and Swedish supervisory institutions. I myself gave many warnings even publicly10, obviously observed by economic experts but not by financial managers and supervisors. I still cannot understand why many Swedish financial executives never reacted to the strongly increasing deficits in the current balances of Estonia, Lithuania and particularly Latvia (see page 6). Sure, FDI could for a number of years cover all or most of the current account deficits. But we also know that this specific kind of strong currency inflow usually cannot last forever or go on for a long period of time without any distortions. Deficits in the current account mean that a country is living above its means. One would think that all top-level financial managers should understand what kind of risk such an exposure could lead to. This was obviously not the case. It may be somewhat cynical to add but it is a simple matter of fact: All my students use to learn the composition of the balance of payments and of the balance on current account already during the first year at the university. They did this before 2008, too.
Furthermore, journalists did not work much either to illuminate the Baltic risks, which also included inflationary problems, rapidly rising wages and the inflexibility of unilaterally fixed exchange rates. However, the second major post war banking crisis (crisis 3) never became as serious as crisis 1 in the early 1990s. There are four main reasons for this conclusion: - The challenges were not directly located in Sweden or related to the Swedish economy; thus, necessary fiscal austerity measures were taken outside Sweden in the three Baltic states without any mentionable macroeconomic impact on Sweden; - the Baltic states succeeded well in convincing skeptical financial markets that any devaluation of their currencies would be avoided by all means, and the austerity packages were very tough and demanding; by the way, the population showed a lot of understanding for all these unpopular measures; - Swedbank and SEB were most of the time regarded as reliable lenders of last resort to their Baltic branch system (but see the remarks below); - simultaneous concerns about the subprime crisis and its global contagion were regarded as more worrisome in a nervous international/global perspective. Despite these four factors, there were periods of worries about the Swedish banking system all the same. Only recently, the Riksbank published an evaluation of Swedish monetary policy during 2005 and 2010 (authors Goodhart/Rochet) with the conclusion that “the refinancing and liquidity problems of Swedbank and SEB became much more critical than those of Handelsbanken and Nordea”.11 Conclusion 6: New ways of sending important (early) warning messages have to be found, particularly when markets and/or single banks have a completely different opinion. This matter of governance requires more research to get there. The point is how important minority opinions can be launched more effectively. Obvious solutions to this question have not been found yet.
6. General lessons for the future - taken from the Swedish examples There are certainly timeless lessons to be learned from the two real Swedish banking crises that are mentioned in this paper. Some of them are also applicable to the current EMU financial (debt )crisis and the recent global financial crisis that had its starting point in the American subprime crisis. The ten most important general lessons from the Swedish banking crises can be summarized as follows:
¤ Financial exuberance should never be underestimated. ¤ Lack of psychological application made that none of the financial crises was officially attacked in time. ¤ The two heaviest post-war financial crises in Sweden were anticipated by credit booms.
¤ A lack of professional skills were found on all responsible levels, bank executives included. ¤ Crisis 1 and crisis 3 in Sweden were to a great extent aggravated by more or less fixed exchange rates. ¤ Financial deregulation before crisis 1 was accompanied by too many other economic policy changes. ¤ Supervisory authorities coordinated their deregulation analysis and reactions insufficiently. ¤ In the future: At least a small group of economists should be organized directly under the executive management of a financial institution - contrary to the general trend in the past decade. ¤ Top managers have to create better platforms for internal communication and discussion with their analysts and not just pay attention to what certain newspapers write or other top executives say about current/future risks. ¤ Top managers should also should find out and make sure that they do not have “overconfidence” themselves (which Robert Shiller defines as “people think they know more than they really do.” 12). Further general lessons for the future can also be taken from the following chapter 7. Above-mentioned improvements of traditional mathematical forecasting models that also include habits and psychology may not function as a main warning tool any time soon. Initially, once they are here, they may rather serve as an additional analytical input. Thus, the research area of behavioral finance should be developed much further. The still dominating assumption of perfect markets will not make current econometric models effective enough to single out and to combat future asset bubble risks in time . Conclusion 7: In a shorter perspective, statistics, other economic and financial facts and experience combined with different qualitative research areas such as history, psychology, institutions (corporate governance included) should remain the superior approach areas for discovering increasing financial risks in time. Improved modeling that also includes interdisciplinary factors as an additional econometric tool should, however, be regarded as a future interesting analytical potential, also by central banks. But we need some patience and more money for future research in these increasingly important areas.
7. Lessons for China and other emerging economies taken from the Swedish examples Without a doubt, China, India and other emerging countries could learn from some of the negative Swedish examples - particularly when it comes to the avoidance of mistakes that were committed on our deregulated financial markets, both before and in the aftermath of these deregulations. Certain kinds of potential financial crises can, consequently, become somewhat more foreseeable. This is especially true in the aftermath of financial deregulations. Certain signals should simply not be neglected or underestimated. In an article from 1994, I summed up what I entitled “Lessons for survival” 13. This analysis was presented as a list of warnings to other countries to learn from Sweden’s painful deregulation experience which ended - as shown above - in crisis 1. It should also be seen as a hint to deregulated financial markets in emerging economies, which I pointed at in the introduction of that article.
Between 2003 and 2008, I also used the 20 warning signals from my article of 1994 that are summarized below in my own analysis of the Baltic states. This led me quite easily to the conclusion that things were definitely moving in the wrong direction in Latvia, Lithuania and Estonia - unless a fast and decisive policy reversal was established by the banks, the governments and supervisory authorities. However, such a reversal never happened in time. The main issues of my article from 1994 were: Recommendations to governments after major financial deregulations: ¤ ¤ ¤ ¤ ¤ ¤ ¤
Observe the business cycle (for the sake of right timing of deregulation or policy changes)! Restrain fiscal policy if needed! (Temperature in GDP during deregulation should be considered.) Disinflate before deregulating! (Disinflation process can put a real estate markets into a depression). Establish a tax system that does not favor the creation of debt (has to happen before deregulation)! Deregulate gradually! (Market participants need time to adapt to new market conditions). Employ and consult the best economists! (Successful deregulation requires advanced analysis). Take advantage of the experience of other countries (despite partly varying preconditions)!
Recommendations to central banks and (other) supervisory authorities: ¤ ¤ ¤ ¤ ¤ ¤ ¤ ¤
Have a regular dialogue with the government! (Not each deregulation needs approval by a ministry). Tighten monetary policy in case of overliquidity (or use fiscal policy if the economy is overheated)! Give warning signals (which are not always effective, but should not be done too late anyway)! Keep an eye on non-bank lending institutions (big lenders/intermediate players included)! High volume growth? Be careful! (Here we come to a very important psychological observation). Examine the quality of credits! (Collaterals, borrowing sectors in the economy, etc., are central). Tighten rules for single-handed credit and collaterals (when risks obviously rise sharply)! Demand exact reports on off-balance-sheet operations!
Recommendations to banks: ¤ ¤ ¤ ¤
Look thoroughly at the list above! Educate your staff (particularly important for executives, credit officers, branch staff, traders)! Try to find out everything about the own lending exposure (but also the aggregates on the market)! Enforce enough strict and consequent collateral requirements (if the quality of credits is threatened)!
Having looked at my “old” conditions for avoiding financial crises from 1994 - particularly on deregulated financial markets - some further, modernized comments have to be made: First. Financial markets have become much more global since 1991. Markets can attack imbalanced economies earlier, faster and with stronger contagion than was the case twenty years ago.
Second. Rating institutes nowadays - also compared to 2007 - play a much more active role. Thus, markets want to see political action more rapidly than in the beginning of the 1990s once a country has become the victim of warnings, downgrading and/or increasing speculation. Third. Financial products have become much more complicated, and are not always (fully) understandable for many decision-makers and analysts. The subprime complex demonstrates this new reality very clearly. Currently, ETFs (Exchange Traded Funds) confuse a lot of people. Fourth. Financial institutions started acting in a much more regulated financial world after the subprime/Lehman crisis. Risk management of financial institutions has been improved - but will it prove efficient, sufficient and for how long ? Fifth. Currency reserves are now mainly concentrated in Asia - and not OECD countries anymore. Sixth. Central banks and/or other supervisory authorities must be provided with financial resources that make it possible to steadily increase the analytical competence of the staff. This has to be a process. Conclusion 8: Emerging countries - China included - can still learn a lot from the mistakes that were committed before and during the Swedish financial deregulation process.
8. Predictability today and the new role of business economists In this paper, I have already come to a number of lessons and conclusions that can be drawn from the two main post-war Swedish financial crises. We know that business economists worked differently in the 1980s compared to the challenges of today. Then, they did not look very much at financial markets/instruments and their aggregate levels - apart from the development of the monetary aggregates M1 in the U.S. and currency markets. Almost the entire analysis was concentrated on macroeconomic developments and forecasts. Consequently, virtually no attention was paid to the link between microeconomic/microfinancial indicators and macroeconomic developments. This can most certainly be said about Europe, most probably about economic analysis in the United States at that time as well, apart from certain research on emerging markets, for example on Latin America. The application of interdisciplinary research in the forecasting business was still extremely underdeveloped in the 1980. The fundamental work of, for example, Hayek, Buchanan, North, Tullock, Kindleberger, Kahneman, etc. was known - but their results had no major impact on practically oriented business economists or traditional macroeconomists at the universities. Today, (business) economists can no longer work the way they did 20 or 30 years ago, unless they are outstanding specialists in a narrow field. Successful economists have to watch so much: the whole global economy, emerging markets, big countries, small countries, commodities, politics, rapidly expanding
financial instruments, global financial markets on aggregate levels, contagion risks, culture, religion and, of course, new structures in the domestic economy. When I visited London’s financial districts some four years ago, asking about the imbalances in Greece, Portugal and Ireland, almost all economists I met gave the view that the these three countries were “too small to be analyzed”. Today we know that financial markets can become concerned about any economic imbalance. Thus, the field of economic and financial analysis has become much wider, much more cross-border oriented. In Sweden, we still use the term “nationalekonomi”, i.e. “national economics” for what is called “economics” in the Anglo-Saxon world - despite the rapid globalization in the past decade. This little Swedish phenomenon is, however, symbolic for the needs of change in our profession – also when it comes to the attempts of improving predictability of financial crises. Many economists have to change their working methods, too. Conclusion 9: Modern business economists need much broader economic skills than during the past Swedish financial crises. The problem, however, is that such an improvement should not be achieved at the expense of analytical depth. Fast and rapidly changing developments may be an impediment to improved predictability - but not necessarily. It should also be added that modern business economists need much more assistance from economic research, particularly from an interdisciplinary approach. Behavioral finance probably must come in the first place. However, pure psychological research must advance as well in order to give new and improved input into the areas of finance and economics. The priority of behavioral finance does not mean that other interdisciplinary connections should be neglected. Medium-term projections for China, for example - also when considering the risk of a financial crisis there - have their own major political, social, institutional, microfinancial and psychological dimensions. Conclusion 10: Looking at the enormous complexity that influences modern forecasting, it certainly will be difficult to improve the predictability of financial crises. However, every chance of improvement should be taken – even if this seems to be very difficult. More progress requires intensified academic research. This should not be impossible.
Annex: 10 research areas for improved predictability of financial crises ¤ ¤ ¤ ¤ ¤ ¤ ¤ ¤ ¤ ¤
Behavioral finance and its transition into econometric models Financial “literacy” or skills of executive managers, corporate governance Developments from the microfinancial (product) level to macrofinancial aggregates Central banks and their analysis of credit bubbles, asset bubbles and effectiveness of existing tools Consideration of habits in DSGE models Liquidity and liquidity shortage in the financial system Different ways of contagion, speed of contagion, geographical contagion Co-operation between supervisory authorities before, during and after a financial crisis Economic history – lessons from financial crises and their future application in real life Relationships between financial crises in advanced countries and emerging countries, and vice versa.
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