Urban Bäckström: In the wake of financial turmoil
Speech by Mr Urban Bäckström, Governor of Sveriges Riksbank, at the Conference on WorldCom
and Enron - aftermath in the US and lessons for Sweden, held in Stockholm, 5 September 2002.
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Thank you for the invitation to discuss this interesting topic. The circumstances connected with
WorldCom and Enron unquestionably raise some burning questions to do with the roles of the owners,
the boards and the auditors, as well as with construction of the rule system. There is a risk, however,
that a drive for quick solutions will result in hasty conclusions. Experience shows, in my opinion, that
when dealing with complex problems, there is often much to be said for reflection and closer
consideration. In many cases it is not until some time has passed, enabling us to gain a better
understanding of what happened, that we are in a position to take the steps that are truly important
and crucial.
My starting point here is that the events to do with WorldCom and Enron are a part of a broader
context. In the first place they are, of course, directly connected with the recent years' stock-market
bubble. But at a deeper level I believe they stem from two major processes and that, as so often
happens when things go quickly, our current institutions - in a wide sense - have not quite kept up with
the course of events.
• One major process that left its mark on the 1990s is the breakthrough in technology, above
all for computers and telecommunications. This had been on the way for a number of
decades and began to flourish in many parts of the world as it became increasingly clear
what the microchip had to offer. It can be likened to the development of the steam engine in
the late 18th century or the combustion engine and the electric motor a century later. As we
know, those earlier technical breakthroughs had far-reaching consequences for the
development and transformation of our society. The process is not - either then or today - a
simple progression. But the setbacks are manageable and pave the way for new advances.
Many of the setbacks originate in faulty expectations of the new technology's impact.
• The other major process has to do with the financial system's deregulation in recent
decades. As a result, we now have a world where capital markets and capital flows are
about as free as they were before the outbreak of World War One. With the Great
Depression and World War Two, the idea of returning to a less restricted financial system
failed to catch on. It was not until the 1980s that deregulation reached Sweden, after starting
somewhat earlier in many other industrialised countries, including the United States. A free
financial system is needed in order to promote the development of new technology and a
genuine social transformation. But it does also entail a number of risks.
It was the new technology that provided the driving force behind companies such as WorldCom and
Enron, just as it was the supply of capital from the deregulated financial system that enabled them to
grow as they did. But these were not the only enterprises that exploited the new technology and
benefited from the free capital market. It was the euphoria and even hysteria about many companies
that led to the formation of a stock-market bubble. According to some measurements, the average
levels that share prices reached in relation to more fundamental values in the late 1990s were higher
than ever before. So it is hardly surprising that the falling trend in recent years has involved such large
losses around the world. Share prices tend to return sooner or later to values that are a better
reflection of fundamental factors.
A closer look at the recent stock-market bubble reveals a number of more specific features that call for
special reflection. It looks as though share prices for IT and technology oriented companies were
driven primarily by new and rather inexperienced investors, cheered on by managements in need of
capital to cover current spending as well as by analysts from banks and investment companies that
handled the share issues. Media around the world also seem to have lent their voice to this tendency.
Seen in this wider perspective, events in recent years raise a number of questions that I now want to
consider briefly. How should we view financial bubbles, what causes them and what can we do about
them? What drove the latest bubble, what can we learn from it and what is needed more generally to
make stock markets function more efficient?
Nothing new about periods of undue optimism
One important lesson is that in a deregulated world, waves of excessive due optimism can arise and
result in pronounced financial cycles. In the 1990s there were several periods of financial turbulence.
One was Sweden's own bank and currency crisis about a decade ago. At the same time there were
problems in other countries and turbulence in the European exchange rate mechanism (ERM). That
was followed by the crises in Asia and Mexico, the problems with the major hedge fund Long Term
Capital Management, Russia's suspension of payments, the IT bubble and, most recently, the
difficulties in Latin America.
Further back, there have likewise been periods of excessive optimism and financial crises. Here,
briefly, are the most spectacular items in Sweden's economic history.
• The first real financial crisis in Sweden occurred back in 1857. It mainly involved the real
estate market and obliged the government to support the banking system for the second
time in our history. The first occasion had been in 1668, when the Palmstruch Bank was
taken over by parliament and ultimately became what we now call the Riksbank.
• Not long after, in the 1870s, the next wave of excessive optimism had to do with rapid
industrial development, not least the construction of railways. Stockholms Enskilda Bank, for
example, was in difficulties at the height of the crisis in 1878.
• Another serious setback for what was then the "new economy" occurred in 1907. The
potential profits from hydroelectric power and electrification, forest industries and iron ore
had been exaggerated.
• Then we have the undue optimism after the end of World War One, with a major investment
boom and speculation in real estate and shares that peaked in 1921. It may be worth
mentioning that measured in constant prices, it was not until the 1980s that turnover on the
Stockholm stock exchange again reached the level in 1918. That says something about the
strength of the speculation at that time.
• After that, as we all know, there was 1929 and the early 1930s, with a falling stock market,
banking problems and the Kreuger crash as prominent events in Sweden.
• More than fifty years then passed before Sweden experienced another period of genuine
financial turbulence in the late 1980s. The world, including Sweden, was hit by the stock
market collapse in October 1987. A bubble developed in Sweden's real estate market and
subsequently burst, severely damaging the financial system. Resolute action by the political
system in the early 1990s did, however, prevent a financial meltdown that might have
plunged our country into an even deeper crisis.
This brief review shows, I believe, that in periods with a heavily regulated financial system, the world
economy has been somewhat less prone to generate pronounced financial cycles. It should be born in
mind, however, that the regulations also created other problems which impeded long-term growth.
Innovations and new enterprises are hardly stimulated when banks and markets are closely regulated.
So it is symptomatic that the high growth in the 1950s and '60s came mainly from the rationalisation of
existing firms rather than from new enterprises. When the deregulation of trade and of markets for
goods and services got under way again in the decades after World War Two, attention was naturally
drawn to the financial barriers that the tight regulations had set up against future growth. An
awareness of the need for new, expanding companies and the emergence of new markets made it
natural to promote this with a freer financial system.
While this financial deregulation was probably both natural and necessary, it also meant that the world
economy again became vulnerable to the kind of exaggerated optimism, with the attendant risk of
pronounced financial cycles, that had characterised the late 19th and early 20th centuries. Meanwhile,
the institutions connected with the financial system had lagged behind. By "institutions" I mean
everything in and around the financial system that affects its development. Examples are sets of rules,
the banking system as such, the general public, the political system, the authorities and the media.
The shortcomings took various forms. Important rules were wrongly formulated or non-existent. The
banking system lacked the necessary know-how for risk management, both for its own institutions and
for its clients. People had become used to credit being rationed and were now suddenly able to borrow
large amounts. The political system, the authorities and professional economists all stressed the
advantages of deregulating the financial system but were less clear about the risks. In their struggle
for readers, listeners or viewers, the media sometimes forgot to question and scrutinise important
elements of what was happening. Think how much advice about share transactions has been passed
on airily in recent years without a careful scrutiny.
In the early 20th century these financial cycles and the risks of major crises were given a lot of thought
by economists, not least those of the Austrian School. They pointed to the existence of transitory risks
in the process of adjusting to a higher rate of productivity growth in connection with technological
breakthroughs. At first there is a good circle: rising productivity tends to pull share prices up, making it
easier to finance new investments. New investments and a growing capital stock lead through capital
deepening to even higher productivity growth. When productivity goes on rising, however,
expectations may become excessive and push share prices up still more. In certain cases, moreover,
expectations of increased profits may lead to higher lending. All this can generate a vicious circle
where a further increase in asset prices results in a continued expansion of credit.
With excessive euphoria, the expansion of the capital stock may go too far. Sizeable investments are
made in sectors that will never yield the expected return. The subsequent adjustment accordingly
involves a marked fall-off in investment activity and thus a weak development of demand. Both the
excessive investment earlier and the inevitable correction of asset prices contribute to this. The
setback can also lead to problems in the financial system in general.
Much of what the Austrian School had done was forgotten during the half-century of regulation from
the crisis in the 1930s to the 1970s. Political economy was dominated instead by Keynesianism. It
may also be the case that the efficient market hypothesis has been interpreted too freely. This theory
largely amounts to a warning that the market is basically the best judge of a share's real value. Under
normal conditions that is probably true. When a bubble has got under way, however, the market's
normal information processing tends to be disrupted and prices are driven instead by impenetrable
forces of a psychological nature.
In many respects the financial turbulence in the 1980s and '90s was a rude awakening for many
economists, decision makers in economic policy, authorities, representatives of the business and
banking communities and people in general. I find it important to underscore how broad was this lack
of insight into how financial problems arise. One cannot single out a person or group as being solely
responsible for how things took a turn for the worse. Perhaps a society has to undergo a learning
process on a broad front so that earlier mistakes yield new insights.
Economic policy decision-makers like myself are, of course, no exception here. But as financial
turbulence does not inevitably lead to a serious crisis in the real economy, we need to ask why it is
that in certain cases output and employment do suffer severe setbacks and the attendant deflation.
Much will have been gained if we can learn to tell whether or not an extensive share price fall, for
example, besides being troublesome enough for many people, is likely to result in a situation with
general deflation, rapidly falling output and rising unemployment. An answer to that question was
suggested in the summer of 1999 by the Federal Reserve chairman, Alan Greenspan:
While bubbles that burst are scarcely benign, the consequences need not be
catastrophic for the economy. The bursting of the Japanese bubble a decade ago
did not lead immediately to sharp contractions in output or a significant rise in
unemployment. Arguably, it was the subsequent failure to address the damage to
the financial system in a timely manner that caused Japan's current economic
problems. Likewise, while the stock market crash of 1929 was destabilising, most
analysts attribute the Great Depression to the ensuing failures of Policy.
Most things indicate that when banks run into trouble on account of financial turbulence, the supply of
credit may dry up and the payment system cease to function. It is under such circumstances that
output and employment have tended to suffer severely, leading to actual deflation. That, of course, is
what prompted the Swedish political system's resolute intervention at the time of the bank crisis here
about a decade ago. It was a matter, not of protecting the banks as such or their owners from losses,
but of safeguarding the banks' central function in our economy. Maintaining a modern market
economy would be virtually impossible/ without an efficient credit supply and payment system. In the
present context it is positive that the banking sector is functioning well even though stock markets
around the world have fallen steeply in recent years. There are also many signs that the banking
sector has learnt a good deal from the financial problems in the last few decades.
As regards general economic policy, we know that focusing on low and stable inflation creates a better
and securer environment for economic policy decisions on the whole. A credible long-term
commitment to low inflation does away with some of the uncertainty about future income streams,
which are what ultimately determine the fundamental value of various kinds of asset. Such a
commitment should also provide better conditions for financial decisions. But there is more to it than
that. As representatives of the Austrian School pointed out, business cycles are not exactly alike. As a
result of exaggerated euphoria, a basis for risks that may lead to future instability can be created even
before the threat of inflation becomes more visible. In the event of rapidly rising asset prices, with the
associated risk of financial instability, a central bank should therefore keep a watchful eye on credit
expansion in the economy. Under such circumstances the central bank may need to intervene in the
interests of financial stability. In my opinion, interest rate adjustments should certainly not be ruled out
if they are judged to be effective. In other contexts I have mentioned the desirability of such a "flexible
inflation targeting policy" and believe that support for action of this type is to be found in current
legislation. The recent share price bubble was not accompanied by any undue expansion of credit.
This was no doubt partly because the Swedish bank crisis is still so fresh in people's minds and banks
here have made the process of providing credit much more rigorous.
The IT and telecom bubble in the 1990s
So much for financial bubbles in general and what general economic policy can do. There is, however,
more to learn from WorldCom, Enron and the whole of the IT and telecom bubble.
American studies suggest that the new technology which enabled people to do their own share trading
on the Internet attracted many people who were unfamiliar with saving in shares. These new and less
experienced players concentrated in particular on shares that are quoted on the technology oriented
Nasdaq exchange, which greatly influenced the pricing of similar shares around the world. While more
professional and institutional investors accounted for 90 per cent of trading on the New York
exchange, during the stock market boom around half of Nasdaq's turnover came from private
individuals.
Studies also indicate that companies, analysts and banks had incentives to use somewhat
questionable means of attracting inexperienced investors to buy shares in new enterprises. Lacking an
adequate cash flow, many new technology companies were dependent on raising money from new
share issues to pay their employees and procure equipment. That in turn called for a high share
valuation. This gave managements an inducement to "doctor" reports and statements about their
company's future performance. The disclosures about WorldCom and Enron clearly show how an
environment developed in which managements also stood to gain from stretching the accounting
regulations in order to meet market expectations. It also looks as though the same environment left its
mark on the large corporations' auditors, who likewise needed to modify the extent and direction of
their services in order to generate income and profits and survive in the new economy. In certain
respects it amounted to breaking the law. In other instances it was the law that was not sufficiently
clear or extensive.
Analysts and investment banks that earned money by arranging share issues evidently lacked an
incentive to make a critical appraisal of corporate reports and statements. This deprived the
inexperienced investors of the necessary help and support. A look at, for example, the advice that was
provided before stock markets began to fall tells the same tale: recommendations to sell made up less
than one per cent of all advice.
The media latched onto the stock market boom with reports of rapidly rising share prices. Instead of
taking a critical look at what was happening, the notion that the new economy offered chances of
earning a quick profit became the conventional wisdom. The part played by human psychology for
herd behaviour in financial markets has in fact given rise to a new school of financial knowledge,
known as Behavioural Finance. Two key concepts in this analysis are just conventional wisdom and
wishful thinking. There's nothing odd about that. When people make investment decisions they
function in much as the way as in other contexts. A familiar example is our reluctance to enter a
restaurant that is empty - we generally prefer one that already has many guests, particularly if there is
a long queue outside. We simply rely on the good judgement of others and assume that all those
inside have made the right choice. By arriving at a better understanding of how people behave, we
can certainly do a good deal to prevent unduly large mistakes in market pricing and perhaps ultimately
reduce the occurrence of financial bubbles.
Functional institutions are crucial for economic development
Today as well as earlier, the financial turbulence is an additional inducement to create better
conditions in many parts of the economy for the institutions involved in the financial system and
corporate management. It would be wrong to suppose, however, that regulations and other measures
are capable of eliminating financial turbulence altogether. Like the business cycle in the real economy,
cyclical movements in the financial world cannot be excluded as long as a market oriented distribution
of saving and investment is considered desirable. The learning process in which we are all involved
does at least help us to understand the mistakes that have been made and what they can teach us.
The focus at present is very much on the roles and actions of the owners, boards and managements
of listed companies. Self-preservation alone will no doubt lead to much being done to restore investor
confidence in these corporations. Auditors around the world are presumably also devoting a good deal
of thought to their various functions. Accounting issues are very much on the agenda. Many banks are
also considering ways of providing clients with better analytical advice about share investment. A
one-sided producer oriented approach, with the emphasis on getting clients to buy the bank's
products, is unlikely to work in the longer run. Bank managements are tending to look instead at how
to make their approach more consumer oriented. What is good for the client is presumably good for
the bank as well. The structure of internal incentives also needs to be adapted to encourage a
longterm relationship. It seems reasonable to suppose that some newspaper managements are likewise
thinking about how their readers' interests can best be served.
Without in any way claiming to be exhaustive, these examples illustrate the major forces that are at
work in many parts of our society with a view to making things function better than they did in the
recent stock market boom. In addition there are of course the deliberations of economic policy
decision-makers, authorities and international institutions.
The message I want to put across today is primarily that there are no simple solutions that would
prevent a repetition of what we have been through. We must also realise that the spontaneous healing
mechanisms in a market economy can take time to work. They probably need the support of better
institutional rule systems, for example in accounting practice. At the same time, I would be cautious
about intervening too much, for instance by complicating matters with rule systems or unduly detailed
supervision by authorities. It is a question of striking a balance so that the sound forces in the
economy are free to act while tendencies that may develop into a crisis are held in check. How this is
to be achieved is something that market players and the competent authorities continuously have to
consider and try out in the light of experience.