Global Financial Crises, Part II

by: Barry Ritholtz

Earlier, we looked at 5 Historical Economic Crises and the USA.

That discussion led to a reader in Norway referring us to this 2005 commentary about the Norwegian Financial Crisis, which began circa 1987. It was the first systemic crisis in a major industrialized country since the 1930s.

As the nearby chart shows, Real Interest rates in Norway were negative from 1980-84. The crisis hit five years later.

In the United States, real interest rates were negative between 2002-03. The crisis hit five years later (real Interest rates just flipped negative again in 2008).

The Norwegian banking crisis had several features which will look familiar to any observer considering the present deterioration of the US financial situation. Both can be described as classic boom-bust crises, containing several universal features:

Financial Long Island Iced Tea

• Deregulation and liberalization paved the way for the boom
• Macroeconomic policies were largely pro-cyclical
• Lending growth became exceptionally strong
• Prudential capital regulations were relaxed
• Regulatory/Supervision efforts were reduced

The author notes these five factors was "a deadly cocktail." We seem to have drunk the same heady and dangerous brew here in the US. I call it a Financial Long Island Iced Tea -- five liquors mixed with reckless abandon, invariably producing a pounding hangover.

I suspect there will be significant differences in the manner of how the two crisises will be resolved. The Norwegian crisis resolution contained five features:

• Private solutions were explored before the government intervened.
• Share capital was written down to zero before committing public funds.
• The government acted swiftly to limit contagion, but did not provide a blanket guarantee.
• Liquidity support was given to illiquid, but solvent institutions.
• The government did not use an asset management company.

This is a rather intriguing guide to resolving the current sub-prime debacle. Note that the Norwegians avoided any moral hazard, refused to bail out speculators. It will be interesting to see if the US can follow a similar path -- especially with the monoline insurers. Will share capital be written down to zero before committing public funds in firms such as Ambac (ABK), MBIA (NYSE:MBI), FGIC ?

The alternative leads us to a situation where grossly speculative profits remain private, but systemic risk is public. This would be a wholly unsatisfactory conclusion.

A Norwegian perspective on banking crisis resolution
Kristin Gulbransen
Norges Bank, Conference on Banking Crisis Resolution - Theory and Policy, Oslo 16 June 2005

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