In the 4th century BC, Athens and nine other Greek city states defaulted on their loans from the Temple of Apollo at Delos. It was the first recorded financial crisis. Nearly 25 centuries of human evolution, progress and technological advancement later, the modern nation of Greece defaulted in 2012 as a sovereign debt panic seized Europe. It was the latest recorded financial crisis. Look closely at where we stand today and the next one is staring us in the face.
Clearly, little has changed.
Today, in the aftermath of our latest iteration, uncertainties dominate and questions abound as we search for answers yet again. Will Europe resolve its deeply ingrained sovereign debt issues? Can Abenomics reverse two lost decades in Japan? Has the US rediscovered sustainable growth? Are 30,000 pages and a million words of new regulation enough? Are emerging markets powerhouses busted or merely pausing for breath after an orgy of growth? And how does quantitative easing end?
But despite the intellectual ammunition and hand-wringing spent on the above, we continue to miss the point.
Blood and water
Financial crises are not new phenomena. They have been around for centuries and have occurred with an alarming frequency – about once a decade on average for the last 400 years in Western Europe alone, by some estimates.
The genealogy is relentless and impressive. Before the current credit crunch, we had the dotcom crash in 2000 as hypergrowth turned out to be little more than hyper-fantasy; the near Russian default and infamous LTCM fiasco of 1998 that proved two Nobel Prize winning economists don’t necessarily equal a money-making fund; the Asian currency crisis in 1997, which ended in the complete financial and political restructuring of the Asian tigers; the implosion of the Japanese economy in 1990 that contributed the phrase “Lost Decade” to the financial lexicon and is now approaching its silver jubilee without an end in sight; and at the edge of today’s memory, the legendary Wall Street Crash of 1987 that etched Black Monday into cultural memory.
Between the two world wars, the developed world seemed to spend the best part of two decades in perpetual crisis, the notable low point being the lengthy Great Depression. Go further back and we soon lose count, marching into a distant past where China conducted a disastrous experiment with paper money and ancient Greeks and Romans found ample opportunity to bemoan bailouts and vent their spleen at bankers.
There are two clear truisms to be drawn.
First, all it seems you need to generate a financial crisis are people and a medium – money by any other name.
Second, the world is clearly a very complex place, while our brain continues to be only three pounds in weight.
The crush of complexity
The roots to all our crises past, present, and future are to be found in the clash between our simple human nature and the complex societies and economies we create.
The psychological mechanisms that drive us have not changed in thousands of years. What we term rationality is actually bounded on all sides by our emotions, environment and peers. Like geese flying in formation, we move individually through the world but never in isolation. Any change in course impedes on neighbours, affecting their behaviour. Our bounded rationalities overlap and cascade through the flock till suddenly, the whole formation changes course – the new order emerging unbidden from an initial random movement.
Our actions are always less reasoned and more intuited. There are good reasons for this. We take countless decisions everyday with limited knowledge and huge unknowns about future outcomes. Our horizons thus become dictated by our cognitive limits and biases.
These simple myopic decisions in aggregate soon evolve into something far more. The more goods, the more people, the more interactions and linkages, the harder it is to fathom the unintended consequences of our actions and the more we rely on others for direction.
This lends itself naturally to ebbs and flows. What raises it to the architecture of boom and bust is the addition of money to the mix. The two feed off each other, leveraging our innate biases till an entire society resonates in sympathy.
Money becomes another dogma. Financial markets are not static entities. Rather, they are collective nouns for the constant dance of human emotions – optimism, arrogance, greed, fear, and capitulation – around a maypole of trust. Different worldviews vie for dominance, coalescing into transient accepted wisdoms that ebb and flow over time, euphemistically creating the booms and busts we observe.
This then is our perennial reality: a complex world where emotion and money leverage off each other, binding us into vast instinctive herds that charge into uncertainty, striving only for forward movement with little regard for the terrain beneath our feet, running headlong into the myopic horizon and stumbling, only to pick ourselves up, shake our heads, and resume the pursuit of our peers once again.
The nature of the beast
Because we are human and prefer capitalism, we may not be able to prevent this cycle of boom and bust, not without excising human emotion. But knowing how to manage crises and minimise their wider impact is still important.
Financial crises and the speculative booms that birth them have important and lasting effects on economies. Economies are not closed cocoons but have social, political, and, increasingly, international dimensions. Therefore crises also have important and long-lasting effects on governments, hegemonies, and societies. They accentuate tensions, expose structural frailties, and, through repeated application, usher in dramatic shifts.
The long-term management of a society necessitates a long-term perspective. Today, the problem is simple. We have far too much debt in the system. The only way to reignite sustainable growth is if people have the capacity to borrow again. The prospect of much larger debt write-offs in the future is inevitable. We need to be realistic about how much the system can handle.
That takes bold decisions. Making small ones that kick the can down the road do not help. These actions have a horizon far shorter than the complexity they manage. Such a halting approach only strangles confidence, doing far more damage and risking a prolonged stagnation.
We cannot fight complexity with complexity. Individuals respond to shifting incentives. Over time, this creates new permutations of group behaviour that without a clear understanding, will reinforce or create asset bubbles. Like the Gordian knot, simple solutions and a focus on the essentials are needed, else the system again outstrips our understanding. In other words, less Help-to-Buy and more Build-to-Buy; fewer words of regulation and more transparency as well as a legal onus on responsibility; shrinking institutions so that they are never too big to fail; losing our fetish for GDP and conflating all spending with growth; appreciating the structural pervasiveness of debt today; and so on.
Bubbles are born in the minds of individuals, nurtured by the incentives of their environment and grown to adulthood in the complexity of economies. Busts – their aftermath – are dictated by these same forces as well.
It is time we understood that.