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  A Brief History of Doom

  A Brief History of Doom

  Two Hundred Years of Financial Crises

  Richard Vague

  Copyright © 2019 University of Pennsylvania Press

  All rights reserved. Except for brief quotations used

  for purposes of review or scholarly citation, none of this

  book may be reproduced in any form by any means

  without written permission from the publisher.

  Published by

  University of Pennsylvania Press

  Philadelphia, Pennsylvania 19104-4112

  www.upenn.edu/pennpress

  Printed in the United States of America

  on acid-free paper

  10 9 8 7 6 5 4 3 2 1

  A catalogue record for this book is available from the

  Library of Congress.

  ISBN 978-0-8122-5177-7

  CONTENTS

  Prologue

  Introduction: The Anatomy of a Financial Crisis

  Chapter 1. A Jazz Age Real Estate Crisis: The Great Depression

  Chapter 2. The Decade of Greed: The 1980s

  Chapter 3. Denial and Forbearance: The 1990s Crisis in Japan

  Chapter 4. The Dawn of the Industrial Age Banking Crisis: 1819–1840

  Chapter 5. The Railroad Crises Era: 1847–1907

  Chapter 6. The 2008 Global Mortgage and Derivatives Crisis

  Conclusion: The Crisis Next Time—and Policy Solutions

  Notes

  Acknowledgments

  PROLOGUE

  In the mid-2000s, I was a CEO of a large consumer lending bank and had been a banker since the late 1970s. I’d seen my share of financial chaos. My most formative experience was the banking crisis in the Southwest in the 1980s when oil prices collapsed. It was my job to know risk.

  We were national credit card lenders, but as a routine part of our credit and risk analysis, we’d look at loan volumes in many different consumer sectors. “Private debt,” the subject of this book, means the whole range of business and personal debt, including credit card debt, commercial real estate loans, energy sector loans, student loans and, by far the biggest slice of the private debt pie, mortgages.

  In 2005, I began to notice that mortgage sector growth was extraordinary, having accelerated from $6 trillion in mortgage loans to $9 trillion in just three years. It was a chilling discovery. It’s difficult to exaggerate the enormity of that kind of increase. Unprecedented. Alarming. To create a sense of scale, credit card debt at this time totaled a comparatively small $730 billion.

  With that kind of growth, we could surely anticipate that there would be major delinquency problems in mortgages. I wasn’t a mortgage lender, but I assumed that this magnitude of delinquency would cascade into my business too. We discussed this with other lenders and economists, who mostly maintained that we shouldn’t worry about the growth in mortgages because consumer asset values—that is, the value of stocks and houses—were even further ahead.

  This was, in part, why I left the lending industry. I’d come to see that the view from Wall Street, the corner office, the Federal Reserve, the ivory tower, and Congress is markedly different from the experience of those who borrow and lend. From my perspective, with runaway mortgage debt like this, we were in trouble no matter what. Yes, things seemed fine for the moment, but if the value of houses dropped, then much of the debt would go bad. And even if house values remained high, debt service for many would be so high that they would be forced to sell those houses to pay the debt.

  Although I moved on, I never forgot a hunch that I’d been developing about private debt: if wildfire private debt growth was behind the 2008 economic crisis, then maybe it lurked behind other crises, too, including the Great Depression. So I went to find private debt data on the Depression, a far more challenging task that I had imagined, and my hunch was confirmed. In the late 1920s there had been an explosive, though rarely mentioned, growth in private debt, right before the all-too-frequently invoked stock market crash of October 1929.

  Maybe this was a bigger factor than generally believed.

  I began to think about Japan’s crisis in the 1990s, and when I retrieved data, I saw the very same pattern: runaway growth in private debt had come before the bust and the fall. I was hooked on the project and wanted to see whether my hypothesis applied more broadly. So I convened a team of researchers and analysts to assist in this quest. I also began talking to economists at every opportunity. By now I have spoken to hundreds. These conversations have been invaluable but also troublingly consistent in one regard: for most, private debt is a secondary or peripheral topic and barely mentioned. In fact, private debt wasn’t even a component of most economic forecasting models before 2008.

  That shouldn’t have surprised me. I had been a lender for over three decades, had sat on the boards of both Visa and MasterCard, had aggregate industry statistics on debt at my fingertips, and had reviewed hundreds of economic forecasts. How could I not have known this? It’s a devastating paradox: while private debt is a necessary component of an economy, rapid private debt growth may be the most crucial variable explaining financial crises—and also the most overlooked explanatory factor.

  As my team and I embarked on years of research, I pondered why other economists hadn’t emphasized private debt. Perhaps it’s because the generation of economists in positions of power and prestige in 2008 had grown up during that prolonged period from 1950 to 1980 when private debt was so low that it truly wasn’t much of a factor in economic outcomes. Perhaps it’s because they minimize or neglect the role of private debt in creating new money and thus heightening demand. Another factor might be the outsized influence of the Federal Reserve itself, which historically has not made loans directly to the private sector and thus tends to view the world through the lens of government debt and reserve accounts. Finally, private debt may be overlooked because there is a constituency with the wealth, means, and incentive to promote an unfettered laissez-faire outlook, and there is no well-funded constituency to promote an alternative viewpoint—namely, that unfettered private debt can and often does get out of control.

  If readers take one lesson from this book, I hope it is this: when it comes to financial crises, we’re not in the grip of unseen and hopelessly complex forces. Such crises are neither inevitable nor unpredictable. Runaway private debt and the resulting overcapacity does a better job than any other variable in explaining and predicting financial crises. It is our job to heed those danger signs.

  Introduction

  The Anatomy of a Financial Crisis

  Imagine a future country of Oz, in the year 2030. It was in this imaginary country that citizens became captivated by a radical new invention—heliocars. These cars ran on stored sunlight, could be constructed out of ultralight material, and traveled on monorails at four hundred miles per hour.

  Entrepreneurs scrambled to form dozens of companies that built these monorails, which promised to revolutionize travel. These companies were all heavy users of cash since they needed to buy air rights and right-of-ways, build monorails and heliocars, hire operators and technicians, market the service to customers, and more. Stock sales alone weren’t sufficient to provide the needed capital, so these companies looked to borrow.

  That’s where “infrastructure banks” (IBs) came in. They had been authorized by the Ozian Parliament twenty years earlier to aid capital-intensive, long-term infrastructure projects. Unlike conventional banks, IBs had minimal capital requirements and key tax advantages, and could obtain funding through the tax-free infrastructure bank bonds secured by their loans. They were regulated by the Ministry of Commerce, which had a lighter regulatory touch than the conventional bank regulator
, the Central Bank of Oz.

  Heliorail stocks were the darlings of the stock exchange and soared upward, and the value of the land and associated air rights went up rapidly with them. The more IBs lent, the more monorails were built. Since their loan collateral was increasing in value, IB executives grew bolder and vied with each other to lend larger amounts in this sector. If heliorail stocks were hot, IB stocks were hotter. Some heliorail founders got rich; a handful became billionaires. They hired thousands of new employees, many of whom became rich, too. This spilled over into the broader economy and quickened the pace of gross domestic product (economic or GDP) growth. New heliorail start-ups appeared, further crowding the field. Everyone from the virtual-reality repair guy to the lowly eSports equipment manager was looking for the latest tips on heliorail and IB stocks.

  The commercial real estate (CRE) industry projected that hubs with heliorail service would grow rapidly, so CRE developers began building major new office parks at key points adjacent to these lines. Conventional banks, envious of stratospheric IB growth and profitability, jumped into this lending game. With employment rising, mortgage lenders became more aggressive too.

  Photos of heliorail executives were plastered on the front of every e-magazine and news blog in the country. Conventional banks and IBs who wanted in on their loans hesitated to scrutinize their financials for fear of being shut out. Heliorails hired armies of lobbyists to defend and expand their legislative and regulatory turf and became major contributors to the campaigns of the most influential members of Parliament.

  The economic boom brought higher corporate tax receipts, and the government’s budget turned to surplus. The prime minister of Oz took full credit, claiming, “Oz has entered a new era of prosperity due to the policies of our administration.” But there were now fourteen heliorails serving the capital, Emerald City, alone. None were yet profitable. Firms had vastly overprojected growth in passengers.

  In mid-2033, regulators at the Ministry of Commerce began to express concern about the underwriting standards of IBs, but members of Parliament intervened successfully on their behalf, warning the press that any intervention would interfere with the market and could slow the economy. But with concerns of their own, the investors buying industrial bank bonds began to pull back. Without this needed funding, IBs had to curtail their lending. Executives dismissed this concern, but the change was real. Without new funding, heliorail growth began to decelerate. Some pulled back on service. Companies stopped bidding for air right-of-ways, and those values began to decline.

  Disappointment followed disappointment, but the stock market was slow to absorb the trends. Then in June 2034, the highly respected investment firm of Emerald Sachs warned its clients: “We do not see the possibility of meaningful profitability for any heliorail company as long as this large of a number of companies continue to operate in the sector.”

  In contrast, the CRE office-park boom continued unabated. The CRE industry and conventional banks assumed any problems would be limited to the heliorails. IBs began lending to the CRE industry to try and diversify away from their overreliance on the heliorail industry. Unspoken was the fact that both conventional banks and IBs needed the lucrative fees and interest from CRE loans to offset the emerging problems in their heliorail portfolios.

  Then came a shocking announcement. Yellow Brick Heliorail, the third largest in the industry, reported that after unsuccessfully seeking strategic alternatives, it was discontinuing operations. Other, smaller heliorail companies soon followed. In October, the Ozian 500 stock index, which had gained 64 percent in the previous three years, took a tumble, dropping 38 percent in three weeks. The stock market collapse meant that heliorails could no longer raise funds through stock sales.

  By 2035, enough loans had soured that Oz’s largest IB lender, the First Industrial Bank of Oz, was compelled to disclose a massive multibillion-ozbuck loss. Sixty percent of its loans were heliorail loans. The Central Bank of Oz had been precluded from intervening in IB regulation or supervision, but alarm over the heliorail industry now prodded Parliament to grant it the power to intervene—along with a 375 trillion ozbuck war chest to provide liquidity and capital as needed.

  More failures and near-failures of IBs followed, along with the near-failures of several notable conventional banks that had also been swept up in the craze. But the Central Bank was soon committed to stemming the damage and intervened by infusing institutions with new funds or hastily arranging acquisitions by stronger banks. These years brought massive layoffs at heliocar companies and IBs. Oz’s unemployment rate shot up, and its GDP dropped. CRE activity finally peaked in 2036 and then plummeted when tenants for new office parks failed to materialize, affecting conventional bank-loan portfolio quality. The rapid growth in mortgage loans was followed by rising delinquency and losses, and those lenders pulled back as well.

  The Tinman Political Party—in power during the crisis—was voted out and the Lion Party ushered in, though neither party foresaw the crisis or had any real insight or remedies for it. Government economists viewed it as a “black swan,” an unpredictable event. Legislation was passed with a surfeit of new regulations designed to prevent the next crisis, many of which were misguided. Time heals most wounds. Memories of the crisis faded, and by 2037, Oz’s economy was growing again.

  This hypothetical case describes well any number of crises over the past two hundred years: Britain in 1825, Germany in 1873, Japan in 1907, China in 1999, the United States in 2008, and many others.

  This book is a brief history of financial crises. It emphasizes in particular the rapid growth in loans—which we refer to as private debt—that preceded them. It concludes that almost all financial crises follow a simple if ultimately agonizing equation: widespread overlending leads to widespread overcapacity that leads to widespread bad loans and bank (and other lender) failures. This is the essence of a financial crisis.

  In simplest terms, a bank fails when it makes too many bad loans—for example, when it makes far too many loans for buildings when there aren’t enough tenants to fill them, so the buildings sit empty for years. You might think that this would be a rare blunder, but as you will see, it happens often and has been happening for centuries. When it occurs, most often there is a run on that bank’s deposits and funding, or a regulator steps in, and that bank is closed or is rescued by the government. A financial crisis happens when a lot of banks and other lenders in a given country fail or come so close to failure that they have to be rescued. To truly qualify as a financial crisis, these failures must be so widespread that they involve a significant number of lenders and affect a country’s economic growth.

  Bad loans almost never come in this quantity unless those loans bring widespread overcapacity in one or more of the largest sectors in that economy. In the nineteenth century, that sector was railroads and the associated land purchases and real estate construction; in the twentieth and twenty-first centuries, it has been housing and commercial real estate. When lending leads to too many buildings for the number of tenants available, for example, the owners of those buildings will struggle to repay the loans.

  The formula is straightforward: overlending leads to overcapacity, which makes those loans bad. It’s never subtle. There have to be far, far too many new houses or office buildings or some other “something” built for a crisis to ensue. Overbuilding and overcapacity are at the very heart of a financial crisis because vast overbuilding and overcapacity are only possible through an equally vast amount of overlending. It almost always occurs in a few short years. Building one new high-rise condominium in a given neighborhood in a single year is not a problem, but building ten is, since there are not enough tenants in that short span to support the excess. Overlending itself, because it creates overcapacity, can turn initially good loans bad.

  Almost every financial crisis examined in this book was preceded by extraordinary growth in private debt, especially in ratio to GDP. In comparison, periods of benign private debt growth, su
ch as the in the United States in the late 1960s, the United Kingdom in the 1990s, France in the 1970s, and Germany in the 1980s, have not provoked financial crises. Notably, the government (or public) debt of major, advanced economies has not been much of a factor in financial crises until after the collapse.

  Once a crisis has occurred, repair only comes through time and new capital—time enough for natural growth to absorb the overcapacity and new capital to repair damaged lenders and companies.

  This book’s primary goal is to show that financial crises tend to follow the same plotline. Since the global financial crisis of 2008, there has been heightened interest in how to prevent or mitigate future financial crises. Unfortunately, it is the special purview of regulators, economists, and policymakers in power at the time of a financial crisis to later assert that crises cannot be predicted or prevented and that when a crisis happens, we are in the grip of economic complexities that we can neither foresee nor prevent nor entirely understand. But this betrays those millions who did not cause the crisis but were badly damaged by it, as well as the governments and political systems that were badly disrupted. This book argues to the contrary that financial crises, across time or place, have measurable prerequisites and a predictive indicator—once we start paying attention to lending.

  I examine financial crises over the last two hundred years, primarily in the United States but with detours into the United Kingdom, Germany, France, Japan, and China—which together were the six largest economies on the globe during that span—totaling roughly 50 percent or more of world GDP for that period. I focus on the last two hundred years because it has been a unique era. From the Industrial Revolution onward, both economic and population growth have exploded beyond anything previously seen.