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If another financial shock erupts in the next decade, how well would we curb contagion? If you pitched that question to western regulators right now, their answer would probably be “pretty well”.
After all, in the 15 years since the 2008 great financial crisis, western governments have poured huge resources into learning the right lessons, crafting new regulations, monitoring compliance and fostering culture change.
And last year’s collapse of Silicon Valley Bank suggests that this has partly worked. Yes, regulators and SVB executives made terrible mistakes before the collapse, by failing to see the scale of interest rate risk. But contagion was contained without sparking a wider crash. Hooray.
But before anyone gets too relaxed — or complacent — about the future, they should take note of a couple of messages that emerged this week from a gathering of financial historians at the London School of Economics. Most notably, these academics think there are two oft-ignored issues we need to ponder: the role that memory and political hegemony play in finance — and what happens when these disappear.
The first of these — memory — matters because of an obvious point: humans do not assess risks consistently and dispassionately, as 20th-century economic models often suggest they should. Instead, they parse risk through the lens of “narratives”, to cite the behavioural economist Robert Shiller, which include lived and folk memories.
One key point about memory is that it is not dispassionate — or stable. Consider the 1929 financial crash and Depression. Regulators often assume that the history of this was self-evident and uniformly accepted. Not so: as Tobias Pforr and Giuseppe Telesca, two economic historians, point out, folk memories of 1929 have been fluid and “contentious”, reflecting attitudes towards the Glass-Steagall Act that reformed banks’ business models.
Such fluidity might also soon emerge around the 2008 crisis. Youssef Cassis and Bruno Pacchiotti, of the European University Institute, recently did a survey of 150 top financial executives. This found that three-quarters of them (still) describe it as a traumatic event; so much so that half say the memory of it shapes their companies’ current risk management policies, and a third that it guides business models.
Meanwhile, two-thirds apparently think that regulators were correct to introduce sweeping financial reforms after 2008 — and four in five want these to be maintained, since “markets have short memories and new generations reinvent old practices”, as one participant noted. This is striking, given that it flies in the face of what bank lobbyists typically say.
But the survey also showed that two-thirds of these bankers have worked in finance for more than 10 years and almost half for over 15 years. So, given that the financiers’ career spans are usually short, “it is doubtful” that direct memories of the crisis “will survive another 15 years”, as Cassis and Pacchiotti say. The key question, then, is what happens in the 2030s, and whether enough oldies remember how to stop contagion — and enough newbies listen.
Then there is the second issue: geopolitics. Elise Brezis, an Israeli economist, has recently scoured history books to study whether patterns of financial contagion differ in times of conflict or relative peace. She concludes they do.
When financial crises erupt amid hegemony — that is, when one country or economic system is dominant — that entity can use its overwhelming political and monetary power (ie reserves) to contain shocks, she argues. This happened when the 19th-century British empire was a hegemony. So, too when the 20th-century American-led liberal economic system dominated, via the G7 nations and IMF. Just remember what happened in the 1990s Asian crisis, or 2008, when lessons about the need for co-ordination were learnt.
But when a power balance is highly contested, countries battle each other with monetary and political firepower, making it far harder to stem contagion. One classic example of that is in the interwar years. But Brezis fears this could be repeated, given today’s rising challenges to American power, exploding national debt burdens and the threat of capital wars.
A cynic might retort that not all episodes of financial crisis fit these boxes and the causality might occur in reverse: conflicts tend to spark economic shocks, which then create implosions in finance. A true cynic might also note that if the 21st-century world experiences extreme capital wars, with tight capital controls global finance might become so fragmented that contagion would be stemmed anyway.
Either way, the crucial point is that as geopolitical stresses mount, we should both re-remember the past and try to imagine what might happen in the future if a financial crisis erupted in China, for example, amid deep conflict. Could the G7 and IMF reproduce the type of co-ordinated, contagion-reducing response seen during the 1990s or 2008? If not, who could?
Or, to put it another way, the question haunting finance in the next decade is not just whether we can learn the right lessons from past shocks, but whether there will be a collective commitment among leaders in the future to actually implement them? And while the answer is inevitably unknowable today — and thus impossible to price — the question needs to be asked. Investors forget those interwar years at their peril.
