Introduction There is no easy way to predict a financial meltdown. From the East Asian troubles to the downward spiral in Russia, the world has experienced a number of serious financial crises in recent years. In this interview, Charles Goodhart, Norman Sosnow Professor of Banking and Finance at the London School of Economics and Political Science, explores the systems and behaviour which have led to financial crises in the past, and considers the adequacy of the measures that currently exist to combat such crises.
What are the most obvious signals or warnings of a financial crisis?
Charles Goodhart: If the warnings for a financial crisis were always regular, then people would foresee the crisis and it wouldn't be so severe. The very fact that it is a crisis means that there are rather less in the way of regularities than the ordinary person might think. Until the 1980s, the main cause of most financial crises was government over-expansion, particularly fiscal over-expansion with the deficit rising too fast. In many cases this was accompanied by monetary over-expansion as governments were effectively trying to get the banks to finance their very large deficit. That still is a cause of crisis in many developing countries, but it has been somewhat replaced, as governments have tended to move to balanced budgets, by crises that are caused by private sector over-expansion. The private sector getting excessively into debt, combined with excessive increases in asset prices generated by expectations of future profit that simply cannot be sustained, creates asset price bubbles. So, the shift towards private-sector crises with excessive debt and asset price bubbles has been increasing over the past couple of decades, whereas previously most of the crises arose from government over-expansion.
How do and can exchange-rate systems and behaviour lead to financial problems? What is the impact of the depreciation of currencies?
Goodhart: Many of the crises are caused by countries trying to peg their exchange rate and the peg, for some reason, becoming increasingly hard to sustain or appear credible to investors elsewhere. However, once you are on a peg it is very difficult for governments to get off it, without a great loss of political face. Consequently, governments have far too often maintained a pegged exchange rate beyond the time when it is either sustainable or credible. That eventually does lead to a crisis as people become aware that governments don't have the stomach to undertake the deflationary measures necessary to maintain the peg. There follows a run on the currency and eventually the foreign-exchange reserves get depleted and the whole thing goes up in smoke.
Is that that what happened with the British entry into the Exchange Rate Mechanism in 1992?
Goodhart: Very much so. The kind of crisis that occurred in the ERM was very similar to the Asian crisis that occurred in 1997-98. The pegged exchange rates were attacked one after the other and most of them broke apart under severe pressure. At the beginning of such contagious exercises, it is always the weakest members of the pegged exchange-rate system that is attacked. Once they have been knocked over, there is a tendency for speculation to move on to the next weakest and then the next weakest and so on.
Investors play a very considerable part because capital movements are
now far more important in affecting flows over the exchange market than
trade. The size of capital flows is a multiple now of the size of the
Do you think the monetary policy committee of the Bank of England responded appropriately to the Asian financial crisis in 1997-98?
Goodhart: The Asian crisis involved two factors. First of all, it actually weakened the Asian economies and caused a downturn. Perhaps more importantly, it caused a weakening of confidence in Asia and quite a severe and very rapid weakening of confidence throughout the world. It was largely the need to restore confidence that led almost every central bank to lower interest rates quite sharply in the autumn of 1998--a move that was actually quite successful. I think the credit for this goes to Alan Greenspan and the Federal Reserve Board rather than to the Bank of England, because it was when confidence returned in America that the situation turned around.
What kind of measures, regulatory or otherwise, can be put in place to reduce the risk?
Goodhart: The need for good regulation is extraordinarily important because many of these crises carry with them rapid declines in asset and equity prices, in shares and often in property prices. Recent examples would include the Scandinavian crisis at the beginning of the 1990s and the Japanese crisis, which has lasted throughout the last decade. The real problems occur in an economy when the declining asset prices, particularly of houses and property, interact with a weak banking system to cause either banking failures or a lot of bad debts within the banking system. In response, banks reduce their credit expansion because they don't feel that they can make additional loans, and people lose confidence in the banking system. An interaction between asset-price deflation and banking weakness can cause very severe problems. You need to try and ensure through regulation that the banking system does not take on too much risk, especially during the previous upturn when there is an asset price bubble. You need to ensure that the banking system is strong enough to survive the subsequent downturn.
How globalised are current measures to deal with financial crises, and do you feel that organisations like the International Monetary Fund have done enough in this respect?
Goodhart: The main institutions are the IMF and, to a lesser extent, the World Bank, globally. Some of the continental development banks are the African, Asian, and the European Bank for Reconstruction and Development in the case of Europe. In the Eurozone, there is going to be an interesting role for the European Central Bank in dealing with crises within Europe, should any arise, because the ECB is now the sole operational central bank for monetary-policy purposes in the Eurozone and therefore has a concern over what happens in the whole of the Eurozone. Can the international operations of these institutions be improved? The answer is always "yes, to some extent". This is not an easy exercise to undertake and there is a great deal of argument about what the roles of the IMF, or indeed within the Eurozone, the ECB ought to be. They are at the moment in some flux, with a general view that the roles need to be redefined, but nobody is absolutely sure what exactly they ought to be.