By Chet Yarbrough
Crashes and Crises: Lessons froma History of Financial Disasters
By: Professor Connel Fullenkamp
Great Courses Lecture Series
Connel Fullenkamp (Professor of Economics at Duke University)
Professor Fullenkamp makes one thing clear in “Crashes and Crises”. Financial disasters are an inevitable consequence of all nation-state’ economies, regardless of their form of government. Fullenkamp reaches back to the 1600s to explain how, and why financial disasters are inevitable.
In part, it is because of the nature of humankind. Fullenkamp notes human error and criminality are facts of life. What the public must do is educate itself. History is a teacher that tells the public there have always been hucksters that say they can make you rich with little or no risk. From Charles Ponzi, to Ivar Kreuger, to Bernie Madoff, there have been “get rich schemes” that victimized the public.
From swindlers, to gamblers, to financial model builders, to inept leaders, Fullenkamp recounts American, French, Zimbabwean, Indian, Japanese, Taiwanese, Mexican, Dutch, and German financial disasters. Fullenkamp’s argument is that crashes and crises are a normal part of financial activity. What he explains is that financial crashes and crises are unavoidable, but he suggests they can be mitigated.
Fullenkamp explains how and why technology increases the potential consequence of human error and criminality in financial crises.
Fullenkamp notes the danger of derivative models. They are packaged investments that can be so complicated that only the creators know how they work.
Major investors, like Warren Buffet called derivatives “financial weapons of mass destruction”.
Fullenkamp notes that investment models are often complex. The personal motives of financial model creators, and the lucrative incomes for investment analysts and sellers can make derivatives dangerous. However, Fullenkamp is not against derivative investments. Fullenkamp’s advice is that if you do not understand a derivative investment, and its potential risk cannot be explained, the investor should walk away.
The 2008 world financial crisis is an example of a derivative model that nearly collapsed the American economy.
The derivative model was based on real estate mortgages that were bundled and analyzed to be worth more than their value; particularly, if individual mortgagees went into default.
Because of imprudent lender qualification of mortgagees by companies like Countrywide, more and more bundled mortgage-backed securities became over valued. Many of these mortgages were sold to FannieMae.
When several mortgages in an investment bundle went into default in 2007, investment bundles crashed. FannieMae held many of the mortgages because they were fobbed off by mortgage lenders as soon as home mortgages were closed.
Because of FannieMae’s relationship with the federal government, the U.S. treasury was at risk when mortgagees defaulted.
The federal government was compelled to buy FannieMae’s defaulted mortgages which exacerbated the 2007-08 financial crises.
The derivative’s crash caused financial institutions, investment houses, and individual investors to either fail, or sell their derivatives at a discount. That caused an international economic crisis. It became an international crises because bundled mortgages had been purchased by world-wide investors and institutions, many of which were also invested in the American economy.
The sellers of these mortgage derivatives failed to clearly understand what they were selling or, more greedily, took advantage of their marketability. Fullenkamp implies it is as much the buyer’s as the seller’s fault by making bad investment decisions.
Fullenkamp reaches into history to show many other financial crises and crashes. He covers economic bubbles in tulips, international trade shares, mining stock investment schemes, the economic panic of 1907, the effect of hyperinflation in Germany and Zimbabwe, the 1929 crash, and more recent events like the dotcom bubble, and rogue trader debacles. Many of the bubbles Fullenkamp identifies are a result of investor’s “irrational exuberance”, a phrase used by the former Chair of the Federal Reserve (Alan Greenspan) in the 1990s.
Next, Fullenkamp goes into some detail about the danger of shadow banking. Lending without government oversight becomes more tempting during an economic crises. Shadow banking is unregulated lending that theoretically is not subject to government oversight or regulation. Without checks and balances in a market driven world, unregulated lending hides or distorts GNP growth.
Fullenkamp ends his lectures with a warning about China’s shadow banking. He moderates his warning by suggesting China is not near a crisis, at least at the time of these lectures.
To some listeners, his warning gains some urgency based on China’s declining economy during the Covid19 crises. Of course, Fullenkamp implies shadow banking is a risk to all nation-states in 2020.
Fullenkamp acknowledges the importance of government regulation of financial activity. He notes changes in American law after crises have occurred. He notes a primary example in the secrecy of stock listings that was eliminated by disclosure requirements of the federal government.
Some argue government actions, after the 2008 economic crisis, saved the American economy.
With the economic impact of Covid19, one doubts President Trump, Secretary of the Treasury Mnuchin, and his administration are up to the task of dealing with 2020’s burgeoning financial crises. With the added dimension of social unrest from George Floyd’s murder and Trump’s obnoxious law and order comments, it is difficult to be optimistic.