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Adam smith, let me start by saying, was a remarkable writer, person, and economist. He was in many ways the real founder of economics, starting our science off in resource allocation, income distribution and a host of similar aspects of microeconomics. Despite a number of interesting passages, such as that on debt, however, he was not distinguished as a macro-economist. The hagiography tends either to ignore his weakness in money and banking, as does Samuel Hollander in The Economics of Adam Smith, or to protest that he is much better on the balance of payments [9], or on monetary economics generally [20] than most observers are willing to allow. I yield to none in my admiration for The Wealth of Nations—and in fact recommend to students that they, like Bismarck’s tariff negotiator for Prussia under the Zollverein, Rudolph Von Delbruck, read the hallowed text each night for half an hour before retiring [8, vol. 1]. But it is helpful for Smith’s reputation as a human being to acknowledge that he, like the rest of us, from time to time made a mistake or overlooked a significant aspect of the economy of his day—even on the microeconomic side. I happened to elicit strong protests from two critics at the Glasgow celebration of the bicentenary of The Wealth of Nations when I suggested that Adam Smith was totally unaware of the technological changes taking place in the industrial revolution cooking around him [2, 12]. His other slips not recited in my chapter on that occasion include the remark that Dutch merchants are uneasy at being separated from their capital which is why they unload goods from East Prussia in Amsterdam to look at them before shipping them on to Italy—when the real reason was to repack the grain more carefully to prevent it from exploding from spontaneous combustion under the hot Mediterranean sun [28, Book IV, 422]; or the amateurish and quite unsupported sociology that ascribed French interest in life annuities and tontines to the “fact” that the farmers general (of tax collections and the like) who accumulate wealth are social upstarts, cut off from marrying into the upper classes and too proud to marry their lower-class equals, hence celibate and without heirs [28, Book V, 871–872].

Articolo originariamente pubblicato in Moneta e Credito, vol. 48 n.188, dicembre 1995, pp. 43-67.

That four waves of surges in cross-border indebtedness and surges in prices of securities and of real estate have occurred in 30 years may set a record for global monetary instability. This succession of waves of banking crises might have been a coincidence; the alternative explanation is that one or several of these waves led to increases in cross-border investment inflows that led to increases in the prices of securities in other centers to levels that eventually became too high to be sustained. Obviously the first wave of surges in cross-border flows — which involved the rapid growth in loans from the major international banks to governments and government-owned firms in Mexico and ten other developing countries — was sui generis. Was there a connection between the banking crises in these countries and the surge in the supply of bank loans in Japan in the last half of the 1980s? Similarly was there a connection between the implosion of the prices of securities and real estate in Tokyo at the beginning of the 1990s and the surge in the external indebtedness in Thailand and its neighbors in Southeast Asia in the mid-1990s as well as in the external indebtedness of Mexico, Russia, Brazil, and Argentina? Was there a link between the Asian Financial Crisis that began in mid-1997 and the sharp increase in US stock prices in the next thirty months? And were the sharp increases in the prices of real estate in the United States, Britain, Ireland, Spain, and Iceland between 2002 and 2007 — and in the debt of the governments of Greece and Portugal and Spain in 2008 and 2009 — related to these earlier events?

If many financial crises have a stylized form, should there be a standard policy response? Assume plethora, speculation, panic; what then? Should the government authorities intervene to cope with a crisis and if so when? Should they seek to forestall increases in real estate prices and stock prices as their price increases expand so the subsequent crash will be less severe? Should they prick the bubble once it is evident that the prices of property and corporate shares are so high that it is extremely unlikely that increases in rents and in corporate earnings could be sufficiently rapid and large to ‘ratify’ these lofty prices? When the prices of securities begin to fall, should the authorities adopt measures to dampen the decline and ameliorate the consequences?

Charlie Ponzi is the most famous banker in American history, immortalized in the term ‘Ponzi scheme’. Ponzi owned a small firm that sold its own IOUs, sometimes called deposits, in one of the Boston suburbs in the early 1920s; he promised to pay the buyers of his IOUs 45 percent interest a year at a time when the traditional banks were paying two or three percent. Ponzi’s operation was straightforward — he used the money that he received from the sale of deposits on Wednesday to pay the interest to those who had bought the deposits on Monday. The interest rate that Ponzi paid was so high that most of those who bought the deposits on Monday were happy to keep their money with Ponzi, so they could earn ‘interest on the interest’.

Historians view each event as unique. In contrast economists search for the patterns in the data, and the systematic relationships between an event and its antecedents. History is particular; economics is general. The business cycle is a standard feature of market economies; increases in investment spending lead to increases in household incomes and in GDP growth rates. Macroeconomics focuses on the explanations for the cyclical variations in the rates of growth of GDP around the long-run trend rates of growth and why these trend rates are higher in some countries than in others.

The standard model of the sequence of events that leads to a banking crisis is that a shock triggers an economic expansion that morphs into an economic boom and then euphoria develops; the prices of securities and real estate increase rapidly, much more rapidly than GDP. Then there is a pause in the pace of these increases in the price of securities. A few savvy or lucky investors sell some of their securities to park their speculative gains in a secure store of value. The slowing of the increases in the prices of securities and real estate may induce a more cautious approach by others. Distress is likely to follow as the prices of securities begin to decline. The pattern is biological in its regularity. A panic is likely and then a crash may follow. Lord Overstone, the leading British banker of the middle of the nineteenth century, saw a similar pattern and was quoted with approval by Walter Bagehot: ‘quiescence, improvement, confidence, prosperity, excitement, overtrading, CONVULSION [sic], pressure, stagnation, ending in aquiesence’.1 Overstone identified five stages of euphoria before the financial crisis, or, in his words, the convulsion.

The bankruptcy of Lehman Brothers Holdings, the fourth largest US investment bank, in mid-September 2008 triggered the most severe financial panic and crash in a century. Lehman had been an aggressive buyer of mortgage-related securities; the firm used the money that it obtained from selling its own short term IOUs to buy long-term mortgages. Every investment bank is highly leveraged, but Lehman was at the extreme end of the spectrum in terms of its leverage; its assets were more than thirty times its capital. At times, Lehman’s leverage may have been as much as forty times its capital; at the end of each quarter, Lehman engaged in ‘window dressing’ so that its reported leverage appeared smaller than the leverage that it had had in the previous several months.

The last four hundred years have been replete with financial crises, which often followed increases in the supplies of credit, greater investor optimism, and more rapid economic growth. More and more individuals purchased securities and assets for short-term profits from the increases in their prices. Households became wealthier as the market prices of securities and assets increased, and consumption spending grew. Business firms became more upbeat and invested more. The external indebtedness of many countries increased, and at a pace that was too rapid to be sustainable. The domestic counterpart of the rapid increase in the external indebtedness was that the domestic indebtedness of a group of borrowers in these countries increased at rates that eventually proved too rapid to be sustained. Economic booms followed and then euphoria developed. The increases in the supplies of credit led to sharp increases in the prices of securities and real estate to levels that proved too high to be sustainable.

One of the most ambitious innovations in international finance in the seventy years since the end of the Second World War was the establishment of a common currency for Germany, France, Italy, Spain, and most other countries that were members of the European Union (EU). Eleven of the fourteen EU member countries adopted the euro on 1 January 1999; Britain and Denmark chose to retain their currencies. More than ten countries subsequently have joined the EU and each has either adopted the euro or will do so as one of the conditions for joining the EU.

The first question suggested by the review of the historical record that banking crises occur in waves is the source of the shocks that led to the surges in indebtedness and the prices of securities in the boom that precedes each of these crises. The second is the connection that links the crises that occur at about the same time in different countries — why did Mexico, Brazil, and Argentina have banking crises in the summer of 1982 and why did Iceland and Britain have a crisis at about same time as the one in the United States in 2008.

Consider the birthdates of some of the tallest buildings in the world. The Empire State Building in New York City — 1250 feet tall — was started in 1929, at the peak of a bubble. In the late 1980s it seemed like 80 percent of the building cranes used to construct tall structures were in Tokyo. By the mid-1990s many of these cranes had migrated to Shanghai and Beijing, and then they moved to the Persian Gulf. Now the tallest building is the Burj Dubai in the United Arab Emirates, completed in 2010.