Financial crises are a bit like airplane crashes. Airplanes, and banks, operate well most of the time. But every so often they crash with very bad consequences and our strategy is to do a forensic study of the last crash, see what we learn, and incorporate that learning into the system so that we might prevent the recurrence of the same kind of crash. In aviation, that has made air travel incredibly safe, to the point that, right now, the Civil Aviation Board does not only analyze crashes but they also analyze “near misses” because there are so few crashes that it’s very hard to keep on learning. So near misses are a way to reduce the likelihood of bad things happening that have not really happened.
Banks are different from airplanes in that innovation in banks is happening much faster than innovation in airplanes. So every time there’s a financial crisis, the financial instruments that cause the problem did not exist at the time of the previous crisis. We have never had a repetition of a financial crisis that looks just like the last one.
The 2008 financial crisis involved subprime mortgages that were packaged into asset-backed securities that were rated in a particular way. The previous banking crisis in 1998, the LTCM crisis, involved highly leveraged hedge funds. The financial crisis in the 1980s involved Savings and Loan entities. Every time the airplane that crashes is a completely different airplane and we fix the airplane that crashed, but the one that crashes next is a completely different airplane that was not even in existence at the time of the previous crash. Applying to financial crises the same strategy we apply to airplanes exposes us to the novelties in finance catching us by surprise through crises of types that have never occurred in the past. One of the founding fathers of the United States, Thomas Jefferson, said that the price of freedom is eternal vigilance and I would say that the price of financial stability is eternal vigilance.
I come from Venezuela. I finished my Ph.D. in 1981 just in time for the 1982 Mexican debt crisis that became the Venezuelan debt crisis in February 1983. That opened up a whole so-called “lost decade” of growth in Latin America because of the consequences of that financial crisis. There was a sequence of other financial crises around 1994, triggered around the so-called Mexican Tequila crisis. There was another financial crisis around 1998, triggered by the Russian crisis and its financial contagion. There was yet another sequence of financial crises around 2001-2002 in Argentina, Uruguay, and Turkey.
So while the 2008 financial crisis is the signal event of the U.S. post-war economy, financial crises of an order of magnitude greater are a much more common event in the countries that I have been looking at.
So for those countries, there is an enormous benefit in running their economy in a much safer way and I think that’s a lesson that most countries in Latin America have followed. Most of them are now investment-grade. Most of them have very hefty levels of international reserves. Most of them regulate their banking systems with enormous care.
If anything, they probably have made their financial systems too safe in the sense that there is not enough risk-taking in the system and bank lending to firms is highly restricted. The regulations make it safer for a bank to lend to a household to buy a Mercedes Benz than it is for a bank to lend working capital to a medium-sized firm.
I think that from a Latin American perspective, we really need to understand the trade-off between making sure that there is no financial crisis and making sure that there is enough finance for valuable but risky projects.