To combine risky businesses with riskless funding is, in fact and in principle, impossible. But governments around the world insist on trying to do it anyway.

North America

The lessons of financial history, reprise

Alex J. Pollock

It has been almost seven years since the mid-2006 peak of the spectacular U.S. housing bubble. With an American housing recovery now at last under way, it is a good time to re-state the repetitivelessons of financial history.

The bubble, the panics and crises of 2007-09, and the extended bust and post-bubble doldrums,present a striking case of recurring financial and political patterns. This is true not only in the U.S., but also in the European housing and government debt disasters.

These patterns notably include the painful dilemmas of governments when using taxpayers’ money to offset the losses of financial firms, all in the name of financial stability. The bubble events have already filled dozens of books and thousands of articles in this cycle, but the debates go back at least to 1802, when Henry Thornton, in The Nature and Effects of the Paper Credit of Great Britain, discussed the “moral hazard,” as we now call it, necessarily involved.

Financial systems all involve an uncomfortable, and indeed a self-contradictory, combination, arising from the public’s deep desire to have short-term assets, especially deposits, which are riskless. Governments feed this desire under the rubric of promoting “confidence.” But these short-term instruments fund financial businesses which are inherently very risky, and subject to periodic losses far greater than anyone ever imagined, notably in the financing of real estate.

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It is indeed too bad that the taxpayers get transformed into involuntary equity investors in financial firms in this fashion. But no students of financial history, including the history of government guarantees of deposits and other debt, are surprised by any of the four developments we are considering.

They are even less surprised by the inevitable fifth development, which comes after the crisis: a big increase in financial regulation, with complex and costly new rules and multiplied and expanded regulatory bureaucracies. This is accompanied by the reiterated official promise that “this new regulation will ensure that a financial crisis will never happen again.” But it always happens again anyway.

The great economic historian Charles Kindleberger, considering four centuries of financial history, observed that financial crises occur on average about every ten years. More recently, Carmen Reinhart and Kenneth Rogoff, surveying eight centuries of booms and busts, reached a similar conclusion. Alas, as far as housing and debt cycles go, there is nothing new under the financial sun.

As memorable as the repetitive lessons of our recent financial adventures seem now, will future financial actors sufficiently remember them? On the historical record, one must doubt it.

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