This fall I am taking a course on the “international financial crisis” taught by Jon Macey and Greg Fleming (yes, the former COO of Merrill Lynch). The first assigned reading is a speech that Larry Summers gave at the AEA in 2000 entitled “International Financial Crises: Causes, Prevention, and Cures,”* summarizing the state of the art in preventing and combating financial crises. It’s based on experiences from emerging market crises in the 1990s, and doesn’t even contain a hint that something similar might happen here; however, few people could fault Summers for making that oversight back in 2000, and I certainly won’t.
Many people, including Simon and me, have discussed the similarities between our recent financial crisis and the emerging market crises of the 1990s, so I’ll be brief. The main similarities are excessive optimism that creates an asset price bubble, a sudden collapse of confidence that causes the rapid withdrawal of money and credit, a liquidity crunch, and rapid de-leveraging that threatens solvency. (We have also argued that there are political similarities, but let’s leave that aside for now.) The biggest difference is that instead of being compounded by flight from the affected country’s currency and government debt, in our case the exact opposite happened; investors fled toward the U.S. dollar and Treasuries, making things easier for us than for, say, Thailand. Also, to a partial extent, the parallel requires an analogy between emerging market countries and United States banks; for example, the issue of bailouts and moral hazard arises in the context of the IMF bailing out Indonesia and in the context of the United States government bailing out Citigroup.
Summers’s speech makes a lot of sense, so I’ll just highlight a few points he makes that I think are particularly instructive given our recent experience. I think these are all excellent points. For each one, I’ll quote from Summers, and then comment on its relevance to our situation.