The market turn: From social democracy to market liberalism By Avner Offer, All Souls College, University of Oxford (firstname.lastname@example.org) Abstract: Social democracy and market liberalism offered different solutions to the same problem: how to provide for life-cycle dependency. Social democracy makes lateral transfers from producers to dependents by means of progressive taxation. Market liberalism uses […]
Conference Report: University of Cambridge, 13-14 September 2016
by Sabine Schneider, University of Cambridge
Retracing the path to the Great Recession, Barry Eichengreen has observed how ‘The historical past is a rich repository of analogies that shape perceptions and guide public policy decisions.’ Certainly, recent years have shown that analogies drawn from historical experience are most in demand ‘when there is no time for reflection.’ Beyond the study of banking crises and financial regulation, the past decade of economic turmoil has generated renewed scholarly interest in the evolution and politics of financial capitalism. While the legacy of the Great Recession has profoundly shaken established tenets of mainstream economics, it has also stressed the need for new historical narratives that understand the world economy within the specific cultural contexts, economic ideas and political debates of the past. On 13 and 14 September, the Centre for Financial History at Darwin College, Cambridge, hosted an early career conference to foster an interdisciplinary dialogue about histories of finance, global trade and monetary policy. Over the two conference days, twenty early career scholars and doctoral researchers presented papers that ranged, in period and geography, from medieval Catalonia and eighteenth-century Scotland to pre-war China and post-war Britain. This review will reflect on three major themes of the conference: the art and science of central banking, studies in political economy, and cultural approaches to the history of finance.
Central banking and the formation of monetary policy have resurfaced as key concerns for economic historians since the 2007/8 financial crisis. The debate over the Bank of England’s evolving role as Lender of Last Resort, for instance, was re-examined by Dr Paul Kosmetatos (Edinburgh). His paper analysed Adam Smith’s and Henry Thornton’s differing recommendations for crisis containment as a starting-point for evaluating the Bank’s conduct in 1763 and 1772. Kosmetatos concluded that the Bank’s timely injection of liquidity via the banknote channel during the latter crisis showed that ‘the attitude and means of intervention described by Thornton were already practically in place.’ Pamfili Antipa (Banque de France/Paris School of Economics) presented new Bank of England balance sheet data that adds considerably to our knowledge of how the British government financed the Napoleonic and Revolutionary Wars. Her joint research with Professor Christophe Chamley (Boston) revealed that the Bank strategically operated in the secondary market for Exchequer bills in order to re-direct funds to the Treasury. For the post-war period, Oliver Bush’s paper (Bank of England/LSE) investigated Britain’s approach to monetary and macroprudential policies in the years after the UK Radcliffe Report (1959). Based on collaborative research with Dr David Aikman (Bank of England) and Professor Alan M. Taylor (California), Bush presented new findings on the ‘causal impacts of interest rates and credit controls’ on inflation and economic activity.
The evolution and management of modern central banks in mainland Europe and Great Britain formed the focus of three further papers. Starting with the foundation of Germany’s Reichsbank in 1876, Ousmène Mandeng (LSE) explored the role of competition and monetary stability as integral elements of the operation of Germany’s central bank prior to 1890. Mandeng argued that the Reichsbank’s flexible reserve requirements, as well as its rivalry with regional note issuing banks in the market for bills, created an effective, incentives-based system of central banking. Enrique Jorge-Sotelo (LSE) took a micro-historical approach to the Spanish banking crisis of 1931, assessing the criteria the Banco de España employed for the provision and conditions of its emergency loans. In her closing keynote, Dr Anne Murphy (Hertfordshire) examined the origins of modern management practices at the Bank of England. Shedding light on the Bank’s working processes, recruitment, and staff training during the 1780s, Dr Murphy demonstrated that the Bank took important steps towards fostering and monitoring good managerial practice, which over the long run may have aided ‘the development of trust in the British public finances.’
The politics of currency, taxation, and trade shaped a second major strand of the conference. Professor Martin Daunton (Cambridge) delivered a wide-ranging keynote on ‘Bretton Woods Revisited: Currency, Commerce and Contestation’. Shifting the focus away from the predominant narrative of US-UK rivalry at Bretton Woods, Daunton re-evaluated the specific domestic concerns of several Western European and Commonwealth countries, which affected their negotiating positions at the 1944 summit and at subsequent international trade conferences. The League of Nations’ work in the field of trade finance in the years leading up to the Great Depression was re-examined by Jamieson Gordon Myles (Geneva). His paper investigated the League’s failed internationalist efforts, and traced how economic nationalism and beggar-thy-neighbour policies could take hold in the inter-war period. New research on France, China, and Germany prompted further reflections on the impact of global integration in capital markets, and its effect on nations’ public finances. Jerome Greenfield (Cambridge), for example, investigated the political economy of France’s fiscal constitution between 1789 and 1852. Greenfield’s paper elucidated the central government’s rationale for re-introducing and extending indirect taxes after they had been abolished during the French Revolution. Ghassan Moazzin (Cambridge) discussed the Chinese state’s practice of raising capital for public expenses through foreign bond markets in the early twentieth century. His paper demonstrated that the interventions of Western bankers to uphold China’s credit had a critical influence on the political outcome of the Republican Revolution of 1911. Considering the nexus between finance and diplomacy, Sabine Schneider (Cambridge) appraised the role of cosmopolitan financial elites in Germany’s conversion to a gold standard. Her paper examined the semi-official position of Gerson von Bleichröder, private banker and economic advisor to Bismarck, and his interventions in the monetary reforms Germany pursued after unification.
Several papers pointed to the underexplored potential of cultural and social history to broaden our understanding of how economic cultures, ideologies and policies are themselves socially constructed. Owen Brittan’s paper (Cambridge) drew on autobiographical evidence to assess men’s anxiety over bankruptcy and debt in later Stuart England, and revealed how such fears were mediated through ideals of masculinity, honour and economic independence. Henry Sless (Reading) discussed the news reporting of financial events in the Victorian era, while Damian Clavel (Geneva) revisited the speculative bubble in Latin American bonds that gripped investors in the 1820s, focusing, in particular, on how underwriters constructed the notorious story of the ‘fictitious country of Poyais’. Exploring changing cultural attitudes to speculation, Kieran Heinemann (Cambridge) traced the practices of brokers and investors in Britain’s grey market for stocks and shares during the half-century leading up to the Prevention of Fraud Act of 1939. Heinemann recovered a largely forgotten ‘discursive struggle over the boundaries between investment, speculation and gambling’, which still resonates with the concerns of investors and regulators today.
Credit, Currency & Commerce brought together thirty-six junior researchers and senior academics from across history, economics, development economics, business management, and philosophy. Their contributions from a variety of disciplinary angles and methodologies produced lively exchanges on the trajectory of financial and monetary history, and the opportunities it holds for mastering a deeper understanding of the world economy.
The full conference report and programme are available at https://camfinancialhistory2016.wordpress.com/
The conference was generously funded by the Economic History Society, the Centre for Financial History and the Faculty of History at the University of Cambridge. For more information on grants and conference funds: www.ehs.org.uk
 Barry Eichengreen, Hall of Mirrors: The Great Depression, the Great Recession and the Uses and Misuses of History (New York: Oxford University Press, 2015), 377.
 Eichengreen, Hall of Mirrors, 377.
 David Aikman, Oliver Bush, and Alan M. Taylor, ‘Monetary Versus Macroprudential Policies: Causal Impacts of Interest Rates and Credit Controls in the Era of the UK Radcliffe Report’, NBER Working Paper No. 22380 (June 2016).
 Anne Murphy, ‘The Bank of England and the Genesis of Modern Management’, eabh Working Paper, No. 16-02 (August 2016); see also, Anne Murphy, ‘“Writes a fair hand and appears to be well qualified”: the recruitment of Bank of England clerks, 1800-1815’, Financial History Review, 22 (2015), 19-44.
 Murphy, ‘The Bank of England and the Genesis of Modern Management’, 29.
 Carmen M. Reinhardt and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press, 2009), 93.
by Tehreem Husain, The Express Tribune
Post global financial crisis, there has been increased importance on exploring financial history of advanced economies and emerging markets to identify episodes of boom, crisis and regulatory responses from which parallels can be drawn today. In this blog, Tehreem Husain discusses an episode from early twentieth century Indian financial history which narrates the tale of a crisis and the evolution of a regulatory institution-the central bank in its wake.
The importance of India amongst the pool of emerging market economies can be gauged from the fact that it contributed 6.8 per cent to global GDP on PPP basis in 2014. Sustaining this growth track requires robust financial regulatory frameworks which can only come with a thorough understanding of its history and the events which led to the evolution of its crucial building block-the central bank. Researching early twentieth century Indian financial history suggests that the onset of the Great War and the financial crisis that ensued in India gave impetus to the creation of a central banking institution in the country.
The Great War, one of the most expensive wars in history, caused untold loss of human life and damages to economic and social resources. Britain at the forefront of the war went through insurmountable stress to meet financing needs of the war. Stephen Broadberry and other eminent economic historians have estimated that the cost of the Great War to Britain exceeded one-third of the total national income of war years. As the war continued in Europe, its stress spilled over the boundaries of mainland Britain and British colonies also became entangled in human and financial costs. For instance, not only did India contribute approximately 1.5 million men recruited during the war, but Indian taxpayers also made a significant contribution of £146 million to Britain to finance the war.
War times impose huge costs on the entire economy but more so for banks, due to the key role that they play in financing it. The National Bureau of Economic Research published a special volume on the effect of war on banking in 1943. One of the chapters, ‘Banking System and War Finance’, highlighted the crucial importance of commercial banks for Treasury borrowing. Banks constituted the largest purchasers of government obligations in addition to being the single most important outlet for the sale of government obligations to the public during World War II. Going back, similar to the experience of other countries, during the Great War Indian treasury borrowed heavily from the banking system. Debt archives from 1918 show that Rs 503.3 million were raised in the form of loans, Treasury Bills and Post Office Cash Certificates. At the same time government continued to issue fresh currency notes, which contributed to extraordinary liquidity flushing the banking sector (evidenced by a high cash-to-deposit ratio).
Studying the Indian economy during that time period using macro-financial indicator analysis, the relation between the British involvements in the Great War and the evolution of central banking is explored in India. Evidence suggests that exigencies of war-finance and government resorting to banking system to finance expenditures, the latter came under huge strain. A stressed macro and financial environment during the war years further weakened the fragile and fragmented Indian banking system. It led to a contagion like financial crisis accelerating bank failures in the war years and beyond. This crisis went unabated due to lack of a formal regulatory structure.
The near absence of regulatory oversight leading to financial crisis gave impetus to the creation of a central banking authority. Although the idea of a ‘banking establishment for India’ dates back to 1836, as a consequence of this episode, restructuring and reforms process ensued. This led to the introduction of a quasi-central banking institution, the Imperial Bank of India in 1921 and finally the creation of a full fledged central bank – the Reserve Bank of India, in 1935. In general, as argued by economists Stijn Claessens and M. Ayhan Kose (2013) deficiencies in regulatory oversight leading to currency and maturity mismatches and resultant financial crisis are applicable to this episode as well.
Interestingly, this episode was not unique to India. In the presence of no regulatory institutions, management and resolution of financial crisis becomes increasingly complex. Historian Harold James has written that the global financial panic of 1907 demonstrated the necessity to America the need to mobilize financial power themselves in the form of a central bank analogous to the Bank of England. The Federal Reserve was created in 1913.
To conclude, one can argue that absence of a formal central banking institution in India resulted in many stressed scenarios for Indian financial system and missed opportunities for the imperial government. This meant that at that time there was no liquidity support available to the failing commercial banks, no control and coordination of credit creation (i.e. no reserve requirements), no mechanism or support for price discovery of the securities to be traded in the primary and secondary markets, etc. A similar argument was given by Keynes in his book ‘Indian Currency and Finance’ supporting the idea of an Indian central bank. Had there been a central bank in India it would have performed three essential functions: (a) assist the government in flotation of bonds or other government securities to the commercial banks, (b) provide direct lending to treasury in the form of ways-and-means advances or by purchase of government securities, and (c) provide reserves to the commercial banks to help them buy government obligations and offer them guidance and support to carry on as much of their traditional task of financing trade and industry as was compatible with a maximum war effort.
This article was based on the working paper ‘’Great War and Evolution of Central Banking in India”.
 Claessens, S., and Kose, M.A, 2013,” Financial Crises: Explanations, Types and Implications”, IMF Working Paper WP/13/28
by Patrick O’Brien (Professor Emeritus,
London School of Economics) and Nuno Palma (Assistant Professor,
University of Groningen)
– Friday 21 October 2016
NEW EHES Working paper
The Bank Restriction Act of 1797 suspended the convertibility of the Bank of
England’s notes into gold. The current historical consensus is that the suspension was a result of the state’s need to finance the war, France’s remonetization, a loss of confidence in the English country banks, and a run on the Bank of England’s reserves following a landing of French troops in Wales.
Read the full post here: http://positivecheck.blogspot.it/2016/10/danger-to-old-lady-of-threadneedle.html
The working paper can be downloaded here: http://www.ehes.org/EHES_100.pdf
by Chris Minns, Economic History Department, LSE
The Great Depression devastated North American labour markets for a decade, with about a quarter of the work force unemployed at the peak of the crisis. It is well known that the headline figure conceals the extent to which the burden of the Depression was shared unequally. In addition to sharp differences in employment patterns between cities and regions, it was less-skilled workers who saw demand for their labour fall more than those able to access white-collar work. Older men who lost their jobs were particularly vulnerable to falling into the trap of long-term unemployment. There is some evidence to suggest that the Depression may have exacerbated ethnic differences in the labour market, with black men in the United States were affected more heavily than their white counterparts. How was the Depression experienced by the foreign-born population who had settled in large numbers in both Canada and the United States up until the early 1920s? A recent research paper by Kris Inwood, Fraser Summerfield, and myself sought to answer this question using statistical evidence drawn from new digital samples of the Canadian Censuses from 1911 to 1931.
There are three reasons we were particularly interested in this topic. First, while some social historians have argued that immigrants suffered greater exposure to labour market discrimination when jobs were rationed in the 1930s, there is surprisingly little published evidence to confirm or contradict this contention. Second, by focusing on the earnings of immigrants over a twenty year period, we wanted to see whether the experience of the Depression had implications for the long-run labour market adjustment of immigrants relative to native-born Canadians. Third, Canada offers an excellent laboratory in which to conduct this research. The Depression experience in Canada was comparable to the United States in terms of unemployment trends in the early 1930s, and the country was a leading destination for European immigrants from the late 19th century. A unique feature of early 20th century Canada was that Census questionnaires asked respondents to report their earnings beginning in 1901. This means that our measure of attainment can reflect changes in pay within occupations and the effects of spell of unemployment on total earnings.
Our analysis of Census earnings yields a striking pattern: immigrants experienced “reverse assimilation” in Canadian labour markets, with the gap in pay between immigrants and the native-born growing between 1921 and 1931. Figures 1 and 2 show predicted earnings for immigrants relative to otherwise identical native-born Canadians for young, recent migrants (Figure 1), and older migrants with longer tenure in Canada (Figure 2). Free migrants had unrestricted access to Canada, and came mainly from the United States and the United Kingdom and Ireland. Preferred and non-preferred migrants hailed mostly from Continental Europe. The figures show that the relative decline of immigrant earnings was strongest among older men, even among those who had lived in Canada for decades when the Depression hit. We also find that the effects are focused almost entirely among immigrants from continental Europe who were not native English speakers, with American and British migrants experiencing no reversal in relative earnings.
Figure 1: Predicted relative immigrant earnings, born 1886, arriving 1911
Figure 2: Predicted relative immigrant earnings, born 1871, arriving 1896
The evidence of reverse assimilation is not a statistical artefact due to selective return migration of European migrants, or selective outmigration of Canadian residents to the United States; international migration flows were much lower in the early 1930s than the late 1920s, despite the government encouraging the return of indigent migrants to their home countries. Nor are the problems of migrants accounted for by a skills mismatch created by the differential shocks of the late 1920s and early 1930s, with immigrants having the misfortune of being concentrated in the jobs that were hit hardest. One factor that does account for a large share in the earnings gap is unemployment; immigrants in the 1931 Census were more likely to have lost time out of work than their native-born counterparts. This suggests that one way in which ethnicity mattered in the Depression was that those who were most obviously foreign were the first to lose their jobs and the last to be rehired. But unemployment does not fully account for reverse assimilation, as non-English speaking immigrants from continental Europe experienced a significant decline in weekly earnings between 1921 and 1931, relative to their native-born counterparts.
Our findings point to a disturbing conclusion: apparently well-integrated immigrants were more vulnerable to the adverse effects of a sustained recession than native-born workers with similar skills. Whether this pattern has been repeated in immigrant receiving economies during the recent crisis is an important question for future research.
Going multilateral? Financial Markets’ Access and the League of Nations Loans, 1923-8
Juan Flores (The Paul Bairoch Institute of Economic History, University of Geneva) and
Yann Decorzant (Centre Régional d’Etudes des Populations Alpines)
Abstract: Why are international financial institutions important? This article reassesses the role of the loans issued with the support of the League of Nations. These long-term loans constituted the financial basis of the League’s strategy to restore the productive basis of countries in central and eastern Europe in the aftermath of the First World War. In this article, it is argued that the League’s loans accomplished the task for which they were conceived because they allowed countries in financial distress to access capital markets. The League adopted an innovative system of funds management and monitoring that ensured the compliance of borrowing countries with its programmes. Empirical evidence is provided to show that financial markets had a positive view of the League’s role as an external, multilateral agent, solving the credibility problem of borrowing countries and allowing them to engage in economic and institutional reforms. This success was achieved despite the League’s own lack of lending resources. It is also demonstrated that this multilateral solution performed better than the bilateral arrangements adopted by other governments in eastern Europe because of its lower borrowing and transaction costs.
Review by Vincent Bignon (Banque de France, France)
Flores and Decorzant’s paper deals with the achievements of the League of Nations in helping some central and Eastern European sovereign states to secure market access during in the Interwar years. Its success is assessed by measuring the financial performance of the loans of those countries and is compared with the performance of the loans issued by a control group made of countries of the same region that did not received the League’s support. The comparison of the yield at issue and fees paid to issuing banks allows the authors to conclude that the League of Nations did a very good job in helping those countries, hence the suggestion in the title to go multilateral.
The authors argue that the loans sponsored by the League of Nation – League’s loan thereafter – solved a commitment issue for borrowing governments, which consisted in the non-credibility when trying to signal their willingness to repay. The authors mention that the League brought financial expertise related to the planning of the loan issuance and in the negotiations of the clauses of contracts, suggesting that those countries lacked the human capital in their Treasuries and central banks. They also describe that the League support went with a monitoring of the stabilization program by a special League envoy.
Empirical results show that League loans led to a reduction of countries’ risk premium, thus allowing relaxing the borrowing constraint, and sometimes reduced quantity rationing for countries that were unable to issue directly through prestigious private bankers. Yet the interests rates of League loans were much higher than those of comparable US bond of the same rating, suggesting that the League did not create a free lunch.
Besides those important points, the paper is important by dealing with a major post war macro financial management issue: the organization of sovereign loans issuance to failed states since their technical administrative apparatus were too impoverished by the war to be able to provide basic peacetime functions such as a stable exchange rate, a fiscal policy with able tax collection. Comparison is made of the League’s loans with those of the IMF, but the situation also echoes the unilateral post WW 2 US Marshall plan. The paper does not study whether the League succeeded in channeling some other private funds to those countries on top of the proceeds of the League loans and does not study how the funds were used to stabilize the situation.
The paper belongs to the recent economic history tradition that aims at deciphering the explanations for sovereign debt repayment away from the gunboat diplomacy explanation, to which Juan Flores had previously contributed together with Marc Flandreau. It is also inspired by the issue of institutional fixes used to signal and enforce credible commitment, suggesting that multilateral foreign fixes solved this problem. This detailed study of financial conditions of League loans adds stimulating knowledge to our knowledge of post WW1 stabilization plans, adding on Sargent (1984) and Santaella (1993). It’s also a very nice complement to the couple of papers on multilateral lending to sovereign states by Tunker and Esteves (2016a, 2016b) that deal with 19th century style multilateralism, when the main European powers guaranteed loans to help a few states secured market access, but without any founding of an international organization.
But the main contribution of the paper, somewhat clouded by the comparison with the IMF, is to lead to a questioning of the functions fulfilled by the League of Nations in the Interwar political system. This bigger issue surfaced at two critical moments. First in the choice of the control group that focus on the sole Central and Eastern European countries, but does not include Germany and France despite that they both received external funding to stabilize their financial situation at the exact moment of the League’s loans. This brings a second issue, one of self-selection of countries into the League’s loans program. Indeed, Germany and France chose to not participate to the League’s scheme despite the fact that they both needed a similar type of funding to stabilize their macro situation. The fact that they did not apply for financial assistance means either that they have the qualified staff and the state apparatus to signal their commitment to repay, or that the League’s loan came with too harsh a monitoring and external constraint on financial policy. It is as if the conditions attached with League’ loans self-selected the good-enough failed states (new states created out of the demise of the Austro-Hungarian Empire) but discouraged more powerful states to apply to the League’ assistance.
Now if one reminds that the promise of the League of Nations was the preservation of peace, the success of the League loans issuance was meager compared to the failure in preserving Europe from a second major war. This of course echoes the previous research of Juan Flores with Marc Flandreau on the role of financial market microstructure in keeping the world in peace during the 19th century. By comparison, the League of Nations failed. Yet a successful League, which would have emulated Rothschild’s 19th century role in peace-keeping would have designed a scheme in which all states in need -France and Germany included – would have borrowed through it.
This leads to wonder the function assigned by their political brokers to the program of financial assistance of the League. As the IMF, the League was only able to design a scheme attractive to the sole countries that had no allies ready or strong-enough to help them secure market access. Also why did the UK and the US chose to channel funds through the League rather than directly? Clearly they needed the League as a delegated agent. Does that means that the League was another form of money doctors or that it acts as a coalition of powerful countries made of those too weak to lend and those rich but without enforcement power? This interpretation is consistent with the authors’ view “the League (…) provided arbitration functions in case of disputes.”
In sum the paper opens new connections with the political science literature on important historical issues dealing with the design of international organization able to provide public goods such as peace and not just helping the (strategic) failed states.
Esteves, R. and Tuner, C. (2016a) “Feeling the blues. Moral hazard and debt dilution in eurobonds before 1914”, Journal of International Money and Finance 65, pp. 46-68.
Esteves, R. and Tuner, C. (2016b) “Eurobonds past and present: A comparative review on debt mutualization in Europe”, Review of Law & Economics (forthcoming).
Flandreau, M. and Flores, J. (2012) “The peaceful conspiracy: Bond markets and international relations during the Pax Britannica”, International Organization, 66, pp. 211-41.
Santaella, J. A (1993) ‘Stabilization programs and external enforcement: experience from the 1920s’, Staff Papers—International Monetary Fund (J. IMF Econ Rev), 40, pp. 584–621
Sargent, T. J., (1983) ‘The ends of four big inflations’, in R. E. Hall, ed., Inflation: Causes and Effects (Chicago, Ill.: University of Chicago Press, pp. 41–97
Can financial crises be averted by identifying and dealing with overpriced assets before they cause instability? This column argues that during the British Railway Mania of the 1840s, railway shares were not obviously overpriced, even at the market peak, but prices still fell dramatically. This suggests that extreme asset price reversals can be difficult to forecast and prevent ex ante, and the financial system always needs to be prepared for substantial price declines.
by Gareth Campbell, 23 May 2009
Full article here: http://voxeu.org/article/railway-mania-not-so-great-expectations
Keynes and Wall Street By David Chambers (Judge Business School, Cambridge University) and Ali Kabiri (University of Buckingham) Abstract: This article examines in detail how John Maynard Keynes approached investing in the U.S. stock market on behalf of his Cambridge College after the 1929 Wall Street Crash. We exploit the considerable archival material documenting his […]
by William Quinn and John Turner (Queen’s University Belfast)
Although the “speculative bubble” is one of few financial concepts to regularly show up in popular culture, in academic financial economics it is a remarkably controversial topic. There are unresolved debates surrounding what constitutes a bubble, whether bubbles actually exist, whether central banks should take action in order to ‘prick’ bubbles, and why, exactly, bubbles often lead to economic recessions. Even the use of the word “bubble” can provoke the ire of economists: Peter Garber describes it as “a fuzzy word filled with import but lacking any solid operational definition”, whereas Eugene Fama simply states that “the word ‘bubble’ drives me nuts”.
Assuming that bubbles actually exist as a recurring phenomenon, how should they be defined? Charles Kindleberger defined a bubble as any substantial upward price movement followed by a crash. This, however, feels incomplete: if an industry grew due to unforeseeable good news, before shrinking due to unforeseeable bad news, it would not seem accurate to describe the event as a bubble. Peter Garber therefore proposes defining a bubble as “a price movement that is inexplicable based on fundamentals”, which seems more consistent with the popular understanding of the word.
A problem with Garber’s definition is that, although it is more precise, it renders bubbles impossible to identify with certainty. This is because testing for market efficiency always invokes a ‘double hypothesis’ problem: one can never tell whether prices were truly inconsistent with fundamentals, or they just appear to have been because the pricing model used for the test was incomplete. One solution is to avoid using the word ‘bubble’ at all. But given how frequently the concept appears outside of academia, it would be absurd if academic finance had nothing to say on the subject at all. In practice, the most sensible solution is often to revert to Kindleberger’s definition.
Why are economic historians interested in bubbles? There are purely historical reasons to be interested in these events: they have often played a central role in the development of financial markets and corporate law, most notably with the Bubble Act of 1720. However, this is also a field in which the past can directly inform the present. The potentially severe economic consequences of bubbles makes their study essential, but they are also rare events, and acquiring an overview of the subject is almost impossible without a historical perspective. Economic history has therefore recently contributed to three areas of contemporary, policy-relevant debates surrounding bubbles.
The first area is the central question of whether bubbles represent examples of market irrationality. The historical evidence on this point is somewhat mixed. Qualitative evidence has been used to suggest that bubbles result from mass irrationality, or, as Charles Mackay put it, the ‘madness of crowds’. However, closely analysing share prices during famous episodes often contradicts these stories. This is not to say that the price at the peak of a bubble is necessarily “correct”, but there is generally a sense in which it is justifiable. For example, Gareth Campbell has shown how prices during the British Railway Mania, although inaccurate in hindsight, were generally consistent with the pricing models widely used at the time. In practice, these models overestimated the sustainability of high initial dividends. But this is a long way from the ‘madness’ described by Mackay. The evidence from historical bubbles suggest that, while prices might not always have perfectly reflected underlying fundamentals, the popular characterisation of bubble investors as naïve fools absorbed by a speculative frenzy is inaccurate.
The second area is the question of whether central banks should raise interest rates in order to ‘prick’ a bubble, thereby preventing adverse economic consequences if it is allowed to grow. There are strong economic arguments for and against this point, but historical evidence generally suggests that it is a bad idea. Ben Bernanke, amongst others, has argued that the attempts of the Federal Reserve to burst the asset price bubble on the eve of the Wall Street Crash were partly responsible for the Great Depression. Hans-Joachim Voth has convincingly shown that a similar mistake was made in Germany in 1927, with even more severe political consequences. The counter-argument put forward by Nouriel Roubini is that these particular examples involve monetary policy which was ‘botched’, and more well-informed efforts to influence asset prices could be effective. This is theoretically possible, but any historical examples seem insignificant in comparison to the severe consequences of the aforementioned attempts to burst bubbles in the 1920s.
The final area is the question of why financial bubbles are often followed by a recession. Here there are two plausible mechanisms: the ‘wealth effect’ and the ‘debt effect’. The wealth effect argument is that the bursting of the bubble inflicts heavy losses on investors, who respond by decreasing spending, thus reducing aggregate demand. The debt effect argument is that, after the bubble bursts, demand is reduced because the public are less inclined to borrow, and banks are less inclined to lend. A 140-year study by Óscar Jordá, Moritz Schularick, and Alan Taylor finds that, while both of these mechanisms seemingly occur, recessions are much more severe when the bubble was accompanied by a high level of leverage. John Turner in his book Banking in Crisis, has suggested that bubbles which are driven by indebtedness, such as the housing bubble of 2006-07, are particularly dangerous for banking systems and economies.
The recent financial crisis suggested an important connection between real estate investments and bank trouble, especially in the U.S. In fact, this is nothing new. Although financial crises can have multiple and varied causes, real estate investment booms are likely to bode particularly ill for the stability of the financial system. Indeed, in a new…