Financial crashes in the globalization era.

• Author: Osborne, Evan

On December 20, 1994, after more than a year of ballooning loan defaults punctuated by several political crises, Finance Secretary Jaime Serra Puche of Mexico announced that his government's target exchange rate for the Mexican currency would fall from 3.47 to 3.99 pesos per U.S. dollar. Although the action was portrayed as a routine adjustment in Mexico's adjustable exchange-rate system, the government announced just two days later that the peso would float freely. Within a matter of weeks, it plunged to five to the dollar as investors rapidly pulled money out of Mexico. In the aftermath of this collapse of the value of its currency and its financial markets, Mexico slid into an economic depression that resulted in a dramatic increase of immigration into the United States (Hanson and Spilimbergo 1999), a substantial decline of Mexican wages, and other economic upheaval that continued for several years.

The Mexican financial crisis was the first of a series of similar events that rippled around the globe, all of them in developing countries that had received huge inflows of foreign capital. In July 1997, the Thai currency, the baht, collapsed and quickly dragged the Thai economy down with it. Spectacular runs on currency and stock markets spread within days to two nearby nations, Malaysia and Indonesia. After a brief respite, two East Asian economies with much higher standards of living--South Korea and Hong Kong--endured similar collapses, as did Russia and Brazil in 1998 and Turkey in 2000. At the height of the turmoil in 1998, many observers wondered whether the international financial system itself might collapse.

The Mexican crisis and the financial crashes that followed it have at various times been blamed on the premature opening of financial markets to foreigners, unexpected political events, and changes in both U.S. interest rates and the value of the dollar, among other things. In fact, the Mexican crash was the first of what may be a series of similar crashes that will periodically occur when countries with a long history of statist misallocation of resourccs confront globalization. (1) Although measures can be taken to lessen the frequency and severity of such crashes, these events are in large part an inevitable result of a clash between economics in which governments have frequently overridden market prices and altered property rights, on the one hand, and a global investment community that demands that the price system determine how scarce resources are allocated, on the other. Thus, the financial crashes of the globalization era differ at least in degree and perhaps fundamentally from earlier collapses in industrializing nations. Moreover, they perform a vital housecleaning function that will enable countries that undergo them to prosper in the new world in which capital can flow immediately around the globe.

Financial Crashes as Rational Events

It will be helpful at the outset to define the events in question. A financial crash is a sharp, sudden decline in a wide variety of asset prices, such as corporate stock prices and real estate prices, after a prolonged, substantial rise. It is usually (but not always) followed by a similar prolonged slump in economic growth and an epidemic of business failures. Some observers assume that such a sequence must be a mysterious event that can be explained only as the result of ordinarily disciplined investors' foolish decisions to invest in a certain asset either because future returns are inevitable based on past returns (rather than on future profits) or because everyone else is doing the same. Although some economists have attempted to model herd behavior as a rational activity (Banerjee 1992; Bikhchandani, Hirshleifer, and Welch 1992), the notion of financial crashes as the result of investors collectively losing their minds as they pursue imaginary ever-higher returns in defiance of fundamentals is deeply ingrained in the conventional understanding of these events. Presumably for this reason, the rising prices are often referred to pejoratively as manias, whereas the collapses are called panics.

The famous Dutch tulip episode of the seventeenth century often serves as the poster child for such putatively irrational behavior. The tulip was introduced into Europe in the mid-sixteenth century and had become very popular among wealthy Dutch by the early seventeenth century. At the height of the craze in late 1636 and early 1637, money flooded in from Dutch and foreign investors to purchase tulip bulbs, and a `single bulb sold for the equivalent of roughly $45,000 today. In February 1637, the bubble suddenly burst, leaving economic devastation in its wake. For many (such as Krugman 1995), the episode holds lessons centuries later for nations that tolerate excessive speculation in nonproductive activities.

In contrast, Peter M. Garber (1989) has produced a contrary history of the tulip mania that is instructive about the rationality of both asset-price buildups and subsequent crashes. He notes that astronomical tulip bulb prices in themselves were not mysterious because such bulbs are among a select group of assets, such as racehorses and prize bulls, that can reproduce themselves. Hence, the price of such an asset can be much greater than the income stream the asset itself will yield directly. In combination with the fact that the flowers had become highly sought after by people willing to spend a great deal, the prices were no more mysterious than those that might prevail if prized bottles of Bordeaux could yield many generations of copies. In addition, the tulip market had several peculiar features. There was a constant production of new varieties because of unpredictable viral mutations. The value consumers attached to those varieties was highly idiosyncratic. Although many rare types existed, few ended up in high demand. Once they moved into widespread distribution, they were quickly reproduced, making the existing bulbs eventually much less valuable.

A futures market for bulbs was introduced in 1636. Because of Dutch authorities' deep suspicion of "speculative" as opposed to "productive" investment, the courts did not enforce the contracts in that market. However, a desire to maintain reputation could lead frequent traders to adhere to contracts despite short-term incentives to break them, and Garber musters evidence that for most of the bubble period they did comply with the contracts. The exception occurred in the final two weeks before the crash and almost exclusively in associations of people who had no history of participation in the tulip market and who gathered in taverns to trade. Such associations generally traded ordinary rather than unusual bulbs. Because the participants by and large had little net worth and little if any reputation as traders, repudiation was for them an unusually low-cost option. The spectacular collapse of those markets did contaminate the markets for the distinctive bulbs, but on several subsequent occasions the latter demonstrated the same price run-up as in 1637 without a general collapse. The inference Garber draws is that what went on in those markets was an ordinary recurring activity based on fundamentals, and only the peculiar outbreak in the common-bulb markets was aberrant.

Two of those fundamentals deserve mention because they characterize many developing economies today. The first is large potential profits. Consumers in Holland and France evinced a tremendous underlying willingness to pay for certain types of flowers. That such high demand sometimes gave rise to extraordinarily high bulb prices, particularly when combined with the self-reproducing feature alluded to earlier, is not surprising. The second fundamental is great uncertainty. No one could pre-diet with assurance which tulip patterns would become popular. That uncertainty, combined with the high profits and the ability to reproduce rare bulbs rapidly once they had attained sufficient density in the population, made it perfectly reasonable that individual bulb prices would rise dramatically and then suddenly collapse. This pattern has been observed in many other flower markets since that time, suggesting that the supposed mania was (the ordinary bulbs excepted) a typical episode in the flower industry in which rational investors pursued potentially substantial but highly speculative returns. (2)

The lesson is that spectacular escalation of asset prices followed by equally large, very rapid declines in no way requires mass irrationality. That rational investors can collectively heed all the available information and still participate in markets subject to such wild swings suggests that crashes perform a useful function, allowing the market (brutally in some instances) to sort out truly profitable from merely illusory investments. This shake-out function is an underappreciated function of crashes for those who view them as primarily irrational phenomena, and it plays an important part in my story of globalization era financial routs.

Rational Crashes in the Globalization Era

A Long View of Developing Countries and Financial Upheaval

A casual reading of history suggests that rapidly industrializing societies are far more prone to crashes than are either fully modernized or stagnant, preindustrial societies. The United States, for example, had what by modern standards are severe declines in asset prices followed by deep depressions in 1837, 1857-58, 1873-78, 1897, and 1929-39. Since World War II, the most severe recession in Europe or the United States was that of 1981-83, which was not remotely comparable to the sharp downturns of earlier years. (3) The 1987 stock-market crash, though massive, led to no significant economic downturn.

Although the lack of spectacular crashes in the postwar period is sometimes credited to Keynesian macroeconomic management and to the advent of government deposit insurance for individual bank accounts...