The Little Book of Economics Part 7

Leverage is an early warning sign of a crisis. It could be rising corporate debt-to-income ratios, or it could be an entire country's foreign debt as a share of GDP-a feature of Thailand that tipped some off to the 1990s crisis in East Asia.

But leverage can also be hard to spot because borrowers may use subterfuge, creative accounting, derivatives, and outright fraud to hide their debt. When investors realize the truth, all h.e.l.l breaks loose-as with Greece's understated deficit in 2009, Enron's use of off-balance-sheet ent.i.ties in 2000, or Korea's puffed-up foreign exchange reserves in 1997.

When your deadbeat brother-in-law can't repay your loan, he first buys time by claiming the check is in the mail. Likewise, a company or country lurching toward insolvency first claims to be merely illiquid.

Condition 3: Mismatches, the First Coconspirator When an avid mountain climber marries someone who's scared of heights, divorce may be in the cards. Similar mismatches in finance are usually a sign of trouble. A company whose sales are in Indonesian rupiah borrows in dollars. A homeowner whose wages are in Hungarian forint borrows in Swiss francs. A country borrows from foreign banks in some other country's currency. In all these cases, a plunge in the local currency will make it dramatically harder to repay the foreign loan.

Rising dependence on short-term borrowing is often a telltale sign of trouble.

.A similarly dangerous sort of mismatch is borrowing short-term to make long-term investments. Relying on short-term loans is like having to reapply for your job every three months. Good luck if it happens on a day your boss takes a dislike to you! Short-term borrowing spells trouble if interest rates rise sharply or investors balk at refinancing the loans as they come due. In fact, rising dependence on short-term borrowing is often a red flag: it may mean nervous investors won't make long-term loans except at punitive rates. As such, countries, companies, and individuals are often tempted to rely excessively on short-term funding because it is cheaper. Mexico's 1994 peso crisis was precipitated by heavy dependence on short-term borrowing, much of it linked to foreign currencies.

Condition 4: Contagion The failure of one bank, one company, or one hedge fund seldom const.i.tutes a crisis; the threshold is crossed when the panic spreads to others, a phenomenon dubbed contagion. contagion.

Contagion has several causes. One is guilt by a.s.sociation. When Lehman Brothers failed in the fall of 2008, investors began to bet that Morgan Stanley and Goldman Sachs would be next. When Thailand devalued its currency in July 1997, investors naturally worried that Malaysia, Indonesia, the Philippines, and Korea would do the same, since their economic circ.u.mstances were similar. They rushed to sell the local currency, precipitating more devaluation.

Another source of contagion is the fact that countries, companies, and banks have countless relationships with lenders, borrowers, trading partners, and investors often around the world. As a result, the failure of one company can bring down all its counterparties. For instance, if Bank A defaults on a loan to Bank B, Bank B may not be able to pay its loan to Bank C, and so on. The more interconnected a company, the bigger a threat it is to the financial system. Lehman Brothers employed only a tenth as many people as General Motors but its bankruptcy did far more damage because it was much more interconnected.

Earlier in this chapter, I described how someone who is insolvent first claims to be merely illiquid. Yet there are times when, because of contagion, an otherwise healthy hedge fund, bank, or country will become illiquid (that is, unable to borrow), and collapse. In the Depression, insolvency and illiquidity contributed about equally to bank failures.

Condition 5: Elections Crises often come in election years. They are often a result of economic stresses that can only be fixed with painful remedies that politicians running for election don't want to administer. Politicians may ignore or paper over the problem in hopes of addressing it after the election, as Mexico did in 1982 with the Federal Reserve's help and Greece did in 2009. After Bear Stearns nearly failed in March 2008, Henry Paulson, the Treasury Secretary, didn't seek authority to handle failures at similar firms, like Lehman Brothers, because Democrats in Congress would not act until after that fall's election. Opposition candidates have little incentive to commit themselves to unpleasant courses of action, which leaves a fog of uncertainty. That unsettles investors and causes them to flee, as occurred in Korea in 1997 and Brazil in 1998. The years 2012 and 2016 may be delicate ones for the United States.

Into the Weeds In the wake of the 1987 stock market crash the President's Working Group on Financial Markets, comprising the heads of the Federal Reserve, Treasury, Securities and Exchange Commission, and Commodity Futures Trading Commission, was formed to periodically meet and consult on the stability of the markets. Conspiracy theorists ascribe every inexplicable market rally to the machinations of this "Plunge Protection Team." This endowed them with far too much power and wisdom. In practice, when crises. .h.i.t, the Treasury and the Fed would resort to ad hoc bailouts, jawboning, and prayer.

The sweeping financial overhaul of 2010 aims to tackle crisis prevention more thoroughly. It creates a 16-member Financial Stability Oversight Council, composed of the heads of the federal regulatory agencies and the Treasury Secretary, to look for threats with the power to rein in or even break up anyone dangerous.

Regulators could order the seizure of any big market player (much as the Federal Deposit Insurance Corporation can seize a bank), and close it down while paying off just enough of its debts to contain panic. In theory, the system is saved, fools take their lumps, and taxpayers are protected. In practice, who knows if future politicians will risk the fallout of liquidating a big company? What if it is the government itself that's the cause of the next crisis?

Shortly after the Federal Reserve was created in 1913, John S. Williams, the Comptroller of the Currency, wrote, "Financial and commercial crises or 'panics' . . . with their attendant misfortunes and prostrations, seem to be mathematically impossible." It wasn't true then. It's not true now.

The Bottom Line * Every crisis is different but they share certain traits. An a.s.set price that deviates from historical fundamentals may signal a bubble, but not when or how the bubble will burst.* Debt is a prime suspect in every crisis. Currency and interest rate mismatches, reliance on short-term debt, and moral hazard are all coconspirators.* Crises are spread through contagion: Investors burned on one company or country flee others that look like it. A failing bank pulls down others with whom it trades or has other relationships. Because of contagion, companies or countries that were merely illiquid become insolvent and collapse.

Acknowledgments.

THIS BOOK REFLECTS a lifetime of learning from people too numerous to list. I got my first lessons in economics as a child from my mother, Irene Ip, a practicing economist for many years, now retired. Great editors have taught me to turn the things I discovered about the economy into stories. They include Michael Babad of The Financial Post The Financial Post and and The Globe and Mail, The Globe and Mail, Larry Ingra.s.sia of the Larry Ingra.s.sia of the Wall Street Journal Wall Street Journal (and now the (and now the New York Times New York Times), and in particular David Wessel, my mentor for 11 years at the Wall Street Journal. Wall Street Journal.

There is no more stimulating and rewarding place to write about economics than The Economist. The Economist. I thank John Micklethwait, the Editor, for his encouragement on this book and the opportunity each week to write for the world's most demanding readers; Zanny Minton-Beddoes, our Economics Editor, for accommodating my schedule and for her extensive and valuable suggestions on the text; Rachel Horwood for her incomparable research a.s.sistance; and Jon Fasman for his collegial advice on the trials of writing a book. I thank John Micklethwait, the Editor, for his encouragement on this book and the opportunity each week to write for the world's most demanding readers; Zanny Minton-Beddoes, our Economics Editor, for accommodating my schedule and for her extensive and valuable suggestions on the text; Rachel Horwood for her incomparable research a.s.sistance; and Jon Fasman for his collegial advice on the trials of writing a book.

Many people lent their time and expertise to help me get various sections of the book right. They include Douglas Irwin at Dartmouth College, Jim Horney at the Center on Budget and Policy Priorities, Tom Gallagher at ISI Group, and in particular Ray Stone of Stone & McCarthy Research a.s.sociates. Any errors are my responsibility.

Howard Yoon, my agent, transformed my early concept into a marketable book. At John Wiley & Sons, Debra Englander helped guide the project. Kelly O'Connor's intensive editing under impossible deadlines vastly improved the organization of the book and made it much more readable.

My wonderful children Natalie and Daniel put up with my mental and physical absences. Most of all I thank my wife, Nancy Nantais, who encouraged me to write this book, supported me throughout the long months and late nights it took to finish it, and gave me constant and helpful feedback to the end.

About the Author.

GREG IP IS THE U.S. Economics Editor for The Economist The Economist magazine, based in Washington, DC. His career spans two decades of financial and economic journalism, including 11 years at the magazine, based in Washington, DC. His career spans two decades of financial and economic journalism, including 11 years at the Wall Street Journal Wall Street Journal in both New York and Washington and before that stints at in both New York and Washington and before that stints at The Financial Post The Financial Post and and The Globe and Mail The Globe and Mail in Canada. He appears frequently on television and radio, including National Public Radio, PBS, CNN, CNBC, and MSNBC. He has won or shared in several prizes for reporting. Greg graduated from Carleton University in Ottawa, Canada, with a degree in economics and journalism. He lives in Bethesda, Maryland. in Canada. He appears frequently on television and radio, including National Public Radio, PBS, CNN, CNBC, and MSNBC. He has won or shared in several prizes for reporting. Greg graduated from Carleton University in Ottawa, Canada, with a degree in economics and journalism. He lives in Bethesda, Maryland.