Boom-bust and banking crises in Finland, Norway and Sweden, 1984-1994: Important lessons

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Boom-bust and banking crises in Finland, Norway
and Sweden, 1984-1994 Important lessons
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Main issues

• Boom-and-bust cycles
• Financial liberalization and macroeconomic
  instability
• The critical years, 1984-1992
• Financial deregulation and the lending boom
• Bad banking
• The boom-bust cycle and fiscal policy
• Monetary policy
• The asset price bubble
• The governments handling of the banking crisis
• Conclusions
• Lessons

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Boom-bust cycles and financial crises(not a
complete list)

• Norway (1991-1993)
• Finland and Sweden (1992-1994)
• Japan (1990s)
• Mexico (1994-1995)
• East-Asia (1997-1999)
• Argentine (2000-2002)
• USA (2007-?)
• UK (2007-?)
• Iceland (2008-?)

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The experience of Finland, Sweden and Norway
1984-1994

• Financial deregulation
• Fast growth in lending, consumption, investment
  and asset prices
• A business cycle boom
• The asset bubble bursts (triggered by a
  stochastic shock)
• Decline in consumption and investment
• Recession
• Financial crisis/a speculative attack on the
  fixed exchange rate
• Government rescue of banks
• New monetary policy aiming at low inflation
• Economic recovery.

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Boom-and-bust cycles

• Business cycles before WW I.
• The boom ends with a burst of asset bubbles and a
  financial crisis.
• Asset prices are linked to booms and recessions.
• Banks and the market for loans are essential
  elements of the boom-and-bust cycle.
• Knut Wicksell and Ragnar Frisch The behavior of
  banks is procyclical and potentially
  destabilizing.
• Most economists after WW II believed that
  boom-bust cycles could be eliminated by
  appropriate aggregate demand management.
• This belief was far too optimistic
• Financial globalization The return of the
  boom-bust cycles and financial crises

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The boom-bust cycle (Norway 1984-1993)
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The critical years (Norway)
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Important questions

• Why did previously very stable Nordic countries
  become so ustable?
• Why did the deregulation of the credit market
  trigger such a great credit supply shock?
• Could the financial supervision authorities have
  prevented bad banking and the banking crises?
• Was fiscal policy procyclical?
• How important was the exchange rate policy and
  monetary policy?
• How well did the government handle the banking
  crisis?
• Was there a credit crunch?
• Did international business cycle impulses
  increase fluctuations?

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Inherited economic policy errors from the 1970s
in Norway

• A considerable foreign debt
• A new oil price shock and large exposure to oil
  price risk
• Increasing inflation and unemployment
• No political acceptance of the natural rate
  hypothesis
• The fixed exchange rate was not credible
• A regulated nominal interest rate, a negative
  after-tax real interest rate
• Credit regulations and increasing credit market
  chaos
• Underdeveloped capital markets
• Strong tax incentives to borrow rather than save
• Absence of structual policies to promote economic
  efficiency and productivity growth

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Framework for analysis of business cycles
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Changes in the propagation mechanism

• Credit market deregulation Behavioral change,
  larger interest rate sensitivity in consumption
  and investment
• Fluctuations in aggregate demand changed
  aggregate output and inflation
• Disinflation was not possible without a
  recession.
• The NAIRU-mechanism Excess demand/supply for
  labor fuelled wage growth/moderation
• The investment accelerator was important.
• A fixed exchange rate and free capital mobility
  made monetary policy procyclical. A flexible
  exchange rate would have permitted a stabilizing
  monetary policy, such as after 1999.
• In open market economies the trade balance
  regulates itself over time if fiscal policy is
  sustainable.

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The most important shocks (Norway)

• International shocks International slump and
  inflation impulse in the beginning of the 1980s
• Liberalization of credit triggered a credit
  supply shock after 1984
• Trade shock Oil price decline in 1986. Great
  loss of national income
• Cost shock Wage settlement in 1986 got out
  control
• Interest rate shock A high German interest rate
  after unification
• International shocks International slump and the
  economiccrises in Sweden and Finland (1990-93)

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From low to high real interest rates (after-tax)
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Bad banking in Norway

• Pressure from the banks to reduce capital
  requirements
• Financial Supervision and prudential regulation
  was weak
• Market shares should increase at all cost
• Unrealistic visions and growth ambitions
• Activ sales of loans to speculative projects.
• Low quality of banking, particularly credit risk
  assessments
• Lack of managerial control
• Enormous credit expansion, excessive banking
  capacity
• Large losses abroad unrelated to Norwegian
  economy.
• Many small savings banks were doing fine.

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The growth and decline of bank credit
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Bank capital
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Real stocks of bank loans in Norway, Sweden and
Finland, 1981-96 (1979100)
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Profits before tax, 1980-99 in comm. banks (in
percent of total average assets)
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Profits before tax 1980-99 in savings banks (in
percent of total average assets)
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Abundant credit supply trigged a fall in the
household savings rate
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Monetary policy (Norway)

• The 10 devaluation in 1986 No more
  devaluations policy of disinflation.
• Gradually tighter monetary policy from 1986
• Full liberalization av capital flows fra 1990.
• From currency basket peg to ecu peg in 1990 It
  increased the real interest rate in a slump
• The German unification triggered a high interest
  rate. Monetary policy became very procyclical
  1989-1993
• Speculative attacks againts FIM, SEK and NOK.
  Norges Bank let the krone float in December 1992.
  Good for the Norwegian economy
• 1993-1998 Managed float (flexible exchange rate
  targeting)
• 1999 Inflation target for monetary policy and a
  flexible exchange rate.

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Procyclical monetary policy due to the fixed
exchange rate
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Curbing inflation
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Conclusions from international research
(Kaminsky Reinhart, 1996, 1999)

• The typical order of events (study of 20
  countries, including the three Nordic)
• Financial deregulation
• Fast credit expansion
• Rapid increase in asset prices
• Collapsing asset prices (the bubble bursts)
• Banking crisis and currency crisis (about one
  year later)
• Macroeconomic crisis at about the same time
  (lasting about 1½ years)

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A theory of financial crisis (Allan Gale,
Economic Journal 2000)

• Market failure in financial sector is the cause
  of credit financed bubbles.
• Limited liability and agency problem Investment
  decisions are made on behalf of savers.
• Limited liability Borrower/investor gets the
  benefits of lucky outcomes. Lender/saver bears
  down-side risk.
• Risk shifting Investors take greater risk than
  what savers wish. Information problem prevents
  control by savers.
• Price bubble Credit finance of speculative
  investment in assets leads to higher asset prices
  than their fundamental values.
• Expectations important The bubble expands due to
  expectations of future credit growth.
• Start of bubble Financial deregulation easy
  credit for speculation
• Burst of bubble A negative real shock or
  monetary restraint.
• Note The theory predicts that the problem is
  largest in markets for shares and commercial
  real estate.

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Complementary explanations of asset price bubbles

• Deposit insurance could stimulate credit financed
  speculation even further.
• Herd behaviour Under limited information it
  could be rational to do as the other bankers do.
• Management failure Managers of banks did not
  know how to manage banks in a new competitive
  environment.
• Non-rational behaviour More recent research in
  the bordering areas of economics and psychology.
  A promising area of research.

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Real estate price bubbles in Oslo and Stockholm.
Non-residential real estate.
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Capital Injections or Transfers to Banks from
Insurance Funds and Governments,
1988-1993Source S.A. Berg (1997)
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Present values of fiscal costs and revenues in
2001
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Government handling of the banking problems and
crisis management (Norway)

• Early warning
• Increasing losses in non-bank finance companies
  in 1986 og 1987. A sign of bad banking behavior
  
• Phase 1 (1987-1990)
• Problems in some very aggressive and fast-growing
  banks. Solved by the banks Insurance funds, as
  well as mergers and closures.
• Phase 2 (1991-1992) The banking crisis
• Collaps of the three largest commercial banks.
  Quick government rescue by the Government Bank
  Insurance Fund and the Government Bank Investment
  Fund.

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Was the Norwegian governments rescue strategy
appropriate in a macroeconomic perspective?

• Allen Gale (1999) compare Norway and Japan
• Norway
• the governments prompt action in restoring the
  banking system meant that it was quickly able to
  revert to performing its normal economic
  function.
• Japan
• The reaction of the Japanese government was
  initially in stark contrast to what happened in
  Norway. () the government did not provide funds.
  This meant that banks slowly had to make
  provisions for bad loans from operating income
  and unrealized profits on stock holdings. () In
  Japan the presumption was that that economic
  growth would return and this would solve the
  banking problem. () it appears that the
  direction of causality is the opposite of that
  assumed in Japan. A solution to the banking
  problem is necessary to restore growth.

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Crisis and recovery 1990-1995
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Conclusions (1)

• 1. Why so much macroeconomic instability in
  1984-1993?
• Fixed exchange rate and financial deregulation
• Inherited stagflation and political
  procrastination of the 1970s. Disinflation leads
  to a recession. NAIRU-hypothesis not accepted.
• Assymmetric shocks made monetary policy
  procyclical
• Shock 1 The credit supply shock due to credit
  deregulation
• Shock 2 Oil price shock triggered a fiscal
  restraint and drop in petroleum investment in the
  recession
• Shock 3 The German interest rate shock

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Conclusions (2)

• Why did the deregulation of the credit market
  trigger such a great credit supply shock in
  Norway?
• The credit regulations lost their legitimacy and
  had fostered cynism among banks strong desire to
  grow fast before 1984.
• The credit deregulation policy increased
  competition very quickly.
• Inadequate capital requirements and prudential
  regulation
• The underlying demand for credit was very strong
  due to the new housing wealth created by the
  previous deregulation of the housing market and
  the booming stock market (speculative credit
  demand)
• High degree of forced saving in 1983-84

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Conclusions (3)

• Was fiscal policy stabilizing?
• The government was too worried about structural
  current account deficits after the 1986 oil
  shock Fiscal restraint hitting indebted
  households.
• Fiscal restraint policy was continued for too
  long Made the recession and stagnation worse.
• New rules for tax deduction of interest payments
  were badly timed.
• Expansionary fiscal policy in 1991-1993 was very
  helpful in boosting household income and start a
  new upturn.

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Conclusions (4)

• 4. Why no ex post fiscal cost of the Norwegian
  banking rescue in contrast to Finland and Sweden?
• The 1986 oil price shock ended a longer-lasting
  boom and slowed down borrowing and investment
  years before the German interest rate shock. No
  similar early warning shock in Finland and
  Sweden.
• Large oil revenues and low investment improved
  the Norwegian current account quickly, low risk
  premium in the interest rate.
• Expansionary fiscal policy from 1991 without
  credibility problems. More procyclical fiscal
  policy in Finland and Sweden. The aggregate
  demand decline was more dramatic in Finland and
  Sweden.
• Establishing a separate institution to handle
  bad loans may increase the fiscal cost compared
  to re-capitalizations of banks by the government.
  

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Remaining questions

• A credit crunch in 1991-1992?
• Most insiders did not think so, but lack of
  research leaves the question unsettled. Macrodata
  looks better than in Sweden/Finland
• Would a good prudential regulation have made a
  difference?
• Credit financed speculation hard to detect due to
  information problems. However With todays
  capital requirements, the crisis would have been
  much smaller, may be non-existent.
• 3. International business cycles Did they make
  things worse?
• Hardly. The international impulses had marginal
  stabilizing effects on Norwegian non-oil exports
  after 1984.
• 4. How important were the speculative attacks i
  1992
• They permitted lower interest rates and better
  monetary polices.

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Main lessions

• Financial markets cannot work on their own
  Government institutions and appropriate policies
  must be in place before financial
  liberalization.
• Macroeconomic policy should account for that
  highly leveraged households and firms could
  amplify the crisis.
• Households and firms should not borrow in foreign
  currency
• If banks loose confidence due to heavy losses,
  they should be re-capitalized quickly, by
  government capital injections if necessary.
• In a banking crisis, dont garantee all deposits
  independent of size. Otherwise, moral hazard
  could distort the money market and increase the
  fiscal cost of a government rescue.
• Basel II capital reqirements could amplify
  boom-bust cycles
• The present rules need to be reconsidered.