Sex lärdomar från historiens största finanskriser

The Babylonians had debt defaults. The S&L scandal led to 2008. What else does the past tell us?

Shut your eyes and picture this: debt is spiralling ever higher, populist protests are rising and a new leader fears a political revolt. So he takes a radical step — forgiving all consumer loans to reboot the economy and revive society.

Is this a description of the future of America, Europe or Japan? You might think so, given fast-rising government debt burdens, the fraught political climate and weak economic growth. But state-sanctioned bouts of debt forgiveness were in fact the preferred socio-economic safety valve of ancient Babylon.

While Babylon did not have money — at least in the sense we know it today — it did have a complex ecosystem of credit between merchants, peasants and the ruling family, recorded on clay tablets. Every few decades, these swelling debts threatened to create a political explosion. So ancient Mesopotamian rulers “would declare a debt release”, says Amanda Podany, an American historian. “They [literally] broke the clay tablets” — that is, symbolically forgave the debt.

Fiscal stress continues to plague the world today, along with an ever-shifting medley of other afflictions. Last week, the IMF and the World Bank held their annual spring meeting in an unseasonably warm Washington, replete with economic forecasts. These include a projection that global public debt to GDP will soar to 100 per cent in 2029, from under 80 per cent in 2015 — and is already 235 per cent if you include private sector debt.

This is alarming given the war in the Middle East, energy markets in turmoil, disruption from artificial intelligence and ructions in the shadowy private credit industry. Shortly before the meeting, Ray Dalio, the founder of the hedge fund Bridgewater, warned that fiscal pressures were fuelling geopolitical conflict, and vice versa and — as he has previously argued — creating quasi “civil war” in America.

“The world economy faces another difficult test,” Pierre-Olivier Gourinchas, the IMF chief economist, said when presenting the IMF’s latest forecasts. “Downside risks are clearly very elevated.”

Even as financiers and economic mandarins peer at the future, some are missing another source of insight, if not policy inspiration: history. While it is easy to assume we live in a unique moment in human evolution, many of the challenges we face today have uncanny echoes of the past. 

“We still analyse the disintegration of the Roman empire, the British empire, the Chinese Empire and the failures after World War I that led to Nazi Germany,” Jamie Dimon, the CEO and chair of JPMorgan, pointed out in his annual letter earlier this month. “However, there are major trends that we should study — they are like shifting tectonic plates that can determine the future course of history.”

The economist John Kenneth Galbraith once joked that “there can be few fields of human endeavour in which history counts for so little as in the world of finance”. In an attempt to address this deficiency, the FT is launching a podcast on the history of finance. The following six lessons from the past remain current today.

No investor likes to lose money in the stock market or on junk bonds. But none should be surprised that it can happen. This is one of the reasons why even major crashes alone are rarely enough to cause major economic problems. The Black Monday crash of 1987 had a negligible economic impact, for example. The S&P 500 lost almost half its value when the dotcom bubble burst in the early 2000s, but that only caused a mild recession. 

However, the financial system tends to buckle when securities that investors assumed were rock solid prove anything but. 

One of the earliest examples is the so-called “Trinity Default” of 1557, when France, Spain and the Netherlands reneged on their debts and “shook the finance and trade of Europe to its foundations”, according to one later account. More recently, it was primarily fears over the safety of even top-grade US mortgage bonds that triggered the financial system breakdown of 2007-08, despite actual losses eventually proving reasonably modest.

Nowadays, US Treasuries serve as the global “risk-free” asset, buttressing not just the American government’s budget but the whole dollar-based global financial system and global banks. History shows that the damage could be immense if that safety is seriously questioned.

Mark Twain famously observed that “it ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Finance is a superb example of this truism. 

Artificial intelligence is one of the hottest themes in finance today, with JPMorgan analysts calling the multitrillion-dollar investment splurge on data centres and power generation to keep them going “an extraordinary and sustained capital markets event”. However, even the $5tn that JPMorgan estimates could be spent on AI and AI-related infrastructure by 2030 pales next to the biggest investment boom in history: the railroad.

The construction which General William T Sherman called “the work of giants” involved a gargantuan capital expenditure financed largely by bonds.

By 1890 railway companies in the US alone had issued about $5bn worth of bonds. Adjusting for inflation that equates to about $180bn in today’s money. However, this understates the enormous scale of the undertaking, because the US economy was much smaller then. In 1890, $5bn was about one-third of America’s GDP, so the investment spree was arguably the equivalent of spending over $10tn today. 

It also resulted in an epic, generation-defining crash. In 1873, Jay Cooke & Co, the premier investment bank run by America’s dominant financier at the time, suddenly collapsed under the weight of unsold railway bonds. This caused a giant financial crisis and ushered in what was long known as the Great Depression, until the even larger one in the 1930s.

As Karl Marx noted with satisfaction in a letter a few years later: “In truth, the railways keep up an appearance of prosperity, by accumulating debts, increasing from day to day their capital account.”

However, the railway boom still transformed America, by knitting together the states and turning the country into an unrivalled industrial powerhouse. Many investors lost their shirts, but the infrastructure they had financed still proved an enormous, century-defining boon. “They created modernity as much by their failure as their success,” according to the historian Richard White. 

Will AI follow a similar trajectory? Will its infrastructure be as durable as train lines? It is unclear. But the parallels are striking.

The obvious lesson of virtually every major financial calamity is worth repeating. Leverage — whether in the form of conventional debt from a bank, a margin loan from a brokerage, or the complex gearing offered through derivatives contracts — is what can transform a conflagration into an inferno. However, its source and nature are constantly shifting. 

Increasingly, one of the main sources of leverage is the so-called repurchase market, or repo.

As the name suggests, this involves the sale and repurchase of financial securities at a slight mark-up, with the premium paid acting as a kind of interest rate for a short-term loan. Imagine selling $10mn of bonds for cash, with the agreement to buy it back for $10.1mn the next week. In practice this means a one-week collateralised loan of $10mn at the cost of $100,000.

Bonds, stocks, real estate and other assets have acted as collateral for loans for as long as finance has been around. Bonds were first invented in 12th-century Venice to finance wars, and were used as collateral for loans soon thereafter. But the modern repo market emerged less than a century ago, when it was started by the new Federal Reserve as a way to facilitate bank purchases of US government bonds sold to finance America’s entry into the first world war.

Since then the repo market has grown enormously in importance and caused a variety of mini-crises and catastrophes along the way, ranging from the failure of Drysdale Securities in 1982 to the collapse of the hedge fund LTCM in 1998. In the global financial crisis of 2008 it was the repo market freezing that killed both Bear Stearns and Lehman Brothers. 

And yet, repo has kept growing and growing since then. The US Treasury calculates that the US market alone is now nearly $13tn, and the International Capital Markets Association, a trade body, recently estimated that the European repo market stands at almost €14tn. 

This might include some double-counting, given that repo is arguably finance at its most opaque and borderless. But what is clear is that the market is a pillar of the global system. Unfortunately, history shows that repo lending can encourage folly and create stress whenever it recoils.

When the Exxon Valdez supertanker ran aground and released 11mn gallons of crude oil off the Alaskan coast in 1989, it inadvertently helped midwife the birth of credit derivatives.

JPMorgan was on the hook for a multibillion-dollar credit line that ExxonMobil drew down to pay for the subsequent clean-up and fines. Uncomfortable with being so exposed to a single client, and weighed down by the capital it had to set aside because of it, the bank asked its derivatives wizards to come up with a solution.

They responded by creating an instrument — credit-default swaps — that provided insurance against bad loans, that could be potentially traded as well.

This had big benefits. But credit-default swaps later spawned wildly complicated synthetic “collateralised debt obligations” that blew up spectacularly in 2008. And the inventiveness of those JPMorgan derivatives bankers also helped inspire another modern-day phenomenon that is starting to worry some regulators, so-called “synthetic risk transfers”. 

SRTs are transactions where banks buy insurance against possible dud loans from investors, and are therefore allowed to retain less capital to buffer themselves against losses. This is now a booming business, with about €750bn of loans now insured across the US, Canada and Europe, according to the Bank for International Settlements, long known as the central bankers’ central bank.

However, despite many regulators cautiously blessing them, “they merit continued monitoring by supervisors as SRT markets continue to grow”, the BIS cautioned in a recent report. That is because complexity can often obscure dangers lurking even inside financial transactions supposedly designed to reduce risks. 

Stablecoins are another hot topic today. Proponents argue that they could make the banking system faster, better, stronger and more equitable, while critics say they could undermine financial stability, nurture crime, enable terrorism and abet rogue nations. As it happens, history offers lessons even here. 

In Antebellum America — the fast-growing but chaotic period between the US war with Britain in 1812-15 and the civil war that erupted in 1865 — what constituted “money” was also an amorphous concept.

The US had no real central bank (the closest it had was refused reauthorisation in 1835), and any state-chartered commercial bank was allowed to issue paper currency, supposedly to be backed by hard assets like gold. However, in practice “it was about as difficult to become a banker as it was to become a bricklayer”, according to Stephen Mihm, a history professor at the University of Georgia.

Indeed, many institutions in what was called the “Free Banking” era flaunted even the loosest of state rules, and became known as “wildcat banks” for their liberal money printing. Counterfeiters thrived in the resulting monetary bedlam. Such was the demand for anything that could serve as money — and with the line between solid bank, wildcat bank and full-on fraud so blurry — that many Americans didn’t care. 

The tumult eventually contributed to the Panic of 1857, which wiped out large parts of the US banking industry. In 1863 the US government passed a National Bank Act that mandated that all banks had to back their note issuance with holdings of US government debt. The Trump administration has sought to do something similar with stablecoins, with the so-called Genius Act stipulating that the crypto tokens must be backed one-for-one by US dollars or other safe assets. 

However, with auditing, regulation and enforcement often a murky affair in the modern world of crypto — Tether, the biggest stablecoin issuer, is mainly supervised by El Salvador — many experts fear the phenomenon will lead to a repeat of the wildcat banking crisis.

The US savings and loans crisis is now almost forgotten. But it featured one of the biggest spates of banking failures in history and helped set the scene for the even grander global financial crisis that erupted in 2008. 

Rising interest rates in the 1970s and 1980s, coupled with longstanding regulations that limited what banks could pay depositors and unwise real estate lending sprees, eventually blew up swaths of small community US banks. The economic toll was severe, and the subsequent clean-up alone cost the US government roughly $200bn, according to a 1993 Congressional Budget Office report. 

However, the main legacy of the S&L crisis was that it helped stoke the growth of the mortgage-backed security market through a misconceived tax break, encouraged the deregulation of the finance industry and inspired the invention of credit derivatives. All three factors played major roles in the 2008 catastrophe. 

Since then regulators around the world have supervised banks much more heavily. This has delivered some successes: it was striking how well the banking system performed during the coronavirus pandemic, given that it was a severe stress test.

But one consequence of the post-2008 reforms is that big banks are less willing to act as market makers for assets such as Treasuries — and their absence increases volatility in a crisis. Another is that risky transactions have shifted from banks into less regulated and more opaque institutions such as hedge funds — the “shadow banking” system that worries regulators today. 

This list is certainly not exhaustive. There are countless other lessons — small and large — that can be learnt from millennia of financial and economic calamities.

Yet the crucial point is that studying history makes us wise. Those who do not are doomed to repeat it, as Winston Churchill once noted. Those Babylonian clay tablets are more than merely museum pieces. 

Data visualisation by Ray Douglas and Patrick Mathurin

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