Section one: A brief history of global meltdowns
Chris Caldwell: Linda, thank you so much for spending the time here to speak to us. It’s much appreciated. When we look at your body of work, the two great themes that come out are: one, you are unbelievable communicator of economic ideas; and two, you’ve got a great feel for history and the lessons we can learn from history. Which leads us to your latest book on economic crises.
Can you tell us a little bit about the premise of the book, and why you decided to write it now?
Linda Yueh: That’s very kind. Being here at London Business School, you have to be able to communicate your ideas. This book, The Great Crashes, follows on my previous book, The Great Economists, and they’re both accessible. They’re meant to introduce the big ideas from history so that we can learn lessons from them. Funnily enough, both of the subtitles of the books refers to lessons: The Great Economists: How Their Ideas can Help us Today and my current book, The Great Crashes: Lessons from Global Meltdowns and How to Prevent Them.
One of the things which I find fascinating, look over the course of economic history is: Mark Twain was right. History doesn’t repeat itself, but it does rhyme. So unfortunately, as we’re sitting here today, we just had if not the largest, then certainly the second biggest bank run in history with Silicon Valley Bank.
So The Great Crashes takes us through all of the major financial crises since the great crash of 1929 that led to the Great Depression of the 1930s. It draws out lessons for how we can try and, as the subtitle says, prevent the inevitable crisis from becoming a global meltdown. In other words, not every crash leads to a systemic banking crisis like you saw in the 1930s, or 10 years ago with the global financial crisis. So this book draws out those lessons and hopes that whilst there will always be a crisis, we don’t have to suffer a decade of recession on the back of it.
Chris: This is unfortunately a subject that people have come back to more than once, which implies that there are lessons that aren’t being learned, and that we’re repeating the mistakes from history. Is there something that is structurally an issue within the economy that causes these crashes to repeat?
Linda: Great point. I think so. Like Mark Twain said, every crisis is somewhat different, but they share common traits and that’s the theme I bring out through the book. The common trait is euphoria. There’s always this belief that the market would just continue to go up, whether that’s stocks or housing. And if that euphoria is fuelled by debt, that is when the inevitable bust could turn into a crisis
In other words, not every stock market crash ends up leading to a recession. Not every housing crash leads to a global meltdown, but the ones that are fuelled with debt unfortunately have the propensity to bring down the banking system, and that’s what leads to very prolonged crises.
The second shared common characteristic across history is credibility. Crises are only resolved when there is credible policy. One of the chapters in the book is on Japan. Now the International Monetary Fund, whose remit it is to look after global financial stability, would normally say that the first 10 months of how you deal with a crisis plays a big role in the aftermath – which of course is something all crises share. Japan took at least four years before they did something about the early 1990s real estate crash, and therefore they ended up with lost decades of economic growth.
Euphoria, the amount of debt, and then the credibility of policy is what all crises share in common. And those together lead to the aftermath. As I say, the worst one-day crash in US stock market history was the 1987 crash of the stock market. But it was hardly a blip on the real economy. However, if you think about the numerous others: the dotcom bubble just as one recent example from the early 2000s that burst, that led to a recession in the US, albeit a shallow one; there was an early nineties recession; there was an early 2000s slow down… you can begin to get a sense that crises are pretty regular. And they do tend to lead to, depending on these factors, an aftermath which could be quite troubling for people as they look at unemployment and they face economic stagnation. And then other times some traders lose money, and nothing happens.
Section two: A crisis response primer
Chris: Okay. So you’ve got some of the signals there – debt, euphoria, a sense that this time is different. What can we do to mitigate it?
Linda: Another great question. The other term that I use in the book is ‘exuberance.’ So euphoria and exuberance tend to be used together. Again, going back to the dotcom bubble, irrational exuberance was coined by Bob Schiller, the Nobel Laureate from Yale University. So how can you mitigate against the exuberance? And the whole point of irrational exuberance is that you can’t – it’s human nature to just believe that asset prices can only go up.
So the key factor there is debt. Can you, as a regulator, try and mitigate the amount of debt that’s offered by the banking system in particular, to try not to fuel that exuberance or that euphoria? That’s one of the differences in a stock market crash that doesn’t lead to a massive economic decline – it’s because there is not a huge amount of debt on the back of it. Some traders might trade on margin, so there is some leverage, but it’s the extensiveness of debt from the banking system which leads to the worst recessions. That’s where regulators can play a role; they can’t do much about human behaviour, but they could try to regulate the amount of debt.
Of course, the most important thing is they can be credible in terms of their policies. For instance, one of the big changes over the past decades since the global financial crisis is that [central] banks now actively use macroprudential policies, like ‘leaning against the wind.’ In other words, what happens is that when the value of an asset, which is the collateral for a loan, goes up, it actually makes it look like the collateral is more valuable on a bank’s balance sheet. So the natural tendency is therefore to say: we could loan more! ‘Leaning against the wind’ essentially says actually, when you have a certain amount of leverage in the system in a macro sense, banks could face regulators saying that we’re going to limit your loan-to-value ratio, or some other way of pushing against this natural tendency for more credit to be available when asset prices are rising.
That’s one example and that is actually a change in Fed policy. Alan Greenspan famously, during the dotcom bubble, tried but found it very hard to take away the punch bowl. In the book I write about that actually dating to 1955, when the then Fed chairman said that for the central bank to lean against, or even try and deflate a bubble, is like taking away the punchbowl when the party is getting started. Now central banks are taking it away, they are deflating things. As I say, it’s inevitable to have a crisis; the only question is how much regulators can try and mitigate the impact.
One of the other things that policymakers can do, and what we saw in the Covid crash they did do, is that they extended extensive income support to people. Because obviously the pandemic was just an incredible hit to so many people. But supporting their incomes – because remember that recessions are when incomes fold – and then extending loans to viable businesses so that they can withstand a liquidity squeeze, those are the kinds of measures which can also help cushion the impact on the real economy.
There’s a number of things that policymakers have the tools to do, but the other thing you mentioned is the sense of ‘this time is different.’ Every crisis is different, and most of the tools are designed for the last crisis. If you look at, for instance, Silicon Valley Bank that I mentioned at the start, it’s a mid-tier US bank. It’s not subject to the same degree of regulation as the systematically important financial institutions. So that’s a great example of: okay, maybe mid-size banks don’t need to be subject to this regime. And it turns out that actually they are systemic, according to the US regulator! That, to me, is why no set of tools can ever be perfect.
Chris: That’s a very good example of the power of lobbying. It seems to me that that the current tools that you’re talking about, regulators have only been exercising them because they’ve been forced to because inflation has gone out of control, and therefore they’re trying to wrestle that punch ball away. But it’s after having had people stumbling around in oblivion for an awful long time, loading an awful lot of debt onto their balance sheets.
Going back to the core of the reaction that regulators have to financial crises, I will slightly misquote Churchill: never waste a good crisis. The way that we react to crises can tell us quite a lot about the priorities of society. This is obviously a conversation on climate; how would you see our reactions to more recent financial crises – from the Great Financial Crisis up to Covid – what has that shown us about our general reaction towards climate and climate change?
Linda: Firstly I should say the I have a chapter in the book which is dedicated to what’s being called The Great Reset. The Covid-19 crash especially just made people sit back and think about the quality of life they want, the kind of society in which they want to live. One of the concerns during the pandemic was with all the focus on public health, would it actually take attention away from the urgency of climate change? And actually it turns out that it’s such an urgent issue that global public goods – encompassing both health and climate – were very high on the agendas of not just policymakers, but (and this is a lesson from history) stakeholders.
During the pandemic, obviously for a time pollution fell because people just weren’t traveling, they weren’t flying. But as economic activity resumed people have begun to think again about whether or not they need to jump on that plane, or where their food is sourced from, or the carbon footprint of their activities. I think that kind of Great Reset, where it’s pervasive across society, is actually how a paradigm shift happens.
In my previous book, The Great Economists, I write about the welfare state which didn’t come into being until the early 20th century. It was triggered by the great depression of the 19th century known as the Long Depression; at that point, unemployment entered the dictionary for the first time. The capitalist society of the Industrial Revolution didn’t have a social safety net. When people became unemployed, when there was a financial crisis, when there was a depression, people thought again and said: this is not the kind of society that we want to live in.
There was a big alternative, which was the rise of communism and socialism. At that time it was a battle of ideas to say, we want to live in a more egalitarian society. Fast forward to today, and it is the destruction of our planet that I write about, which is also essentially a pause and a reset. People will say, I want to live in a greener, fairer society with a better quality of life. This paradigm shift can only happen if you have you have what I described in my previous book; this ‘battle of ideas’ wasn’t just among politicians, it was all of us. That’s how the stakeholders in society play a role.
So on climate we as individuals can vote for politicians who support our values. We can buy from companies that abide by ESG concerns. We ourselves can take action, we can limit our carbon footprint, we can recycle, we can promote net zero. All of that is essentially how de jure laws and regulations can be effected by de facto buy-in, and the consensus shifting. The great crash that we’ve just had with Covid – which was absolutely horrific in the years that people suffered through it – if the lesson we can draw from that is that more people now can work from home, you can see a behavioural change extending to greening the economy and a fairer society on the back of it. To me, those would be the lessons that we should be drawing: recognizing that actually we can as a society stop and change the way in which we work and live. We should extend that and make it a paradigm shift, so that we can protect the environment.
Section three: Should central banks use green mandates?
Chris: I couldn’t agree with you more. I fully understand the point on how you and I and everybody are experiencing these particular changes and having impacts on society, maybe by voting, maybe by buying, maybe by whatever other acts we are taking like not taking airplanes.
What do you think the role of the regulator and the state is in all this? For example, do you see a role for central banks to have carbon as part of their mandates? We’re pretty narrowly focused in on inflation rates. But Europe has also committed to net zero by 2050 (with others talking 2045). Is there a space for the central banks to be told that carbon is also part of your mandate?
Linda: Yes, so I think there’s a huge role for policymakers to play. I think it’s both on the fiscal side and – you mentioned Europe there – the European Central Bank has included sustainability as one of its objectives that it is looking at. Because central banks buy assets, and the introduction of green bonds is another way where projects which are environmentally friendly should be priced differently to bonds which are financing brown assets.
I think all of those things are part of the change that has to happen if we want a paradigm shift. So on fiscal policy, I think it’s very clear that the pandemic support programs done by, say, Germany and France were very geared towards the transition to net zero. For instance, Germany was mandating having charging points in its (probably soon to be no longer called) petrol stations. France was keen on financing green industry.
Governments are all faced with a growth challenge, which is the other longer term structural challenge for lots of advanced economies. The green transition offers the possibility of investing in new innovative industries where the current stock of capital is lower than it is for traditional industries. The IMF made this point when they were arguing that what you would get a higher return from investing in green assets. Leveraging government money that can bring in private money into areas, which, if we think about the possibilities, are just immense – everything from hydrogen to solar. There’s so much investment that could be had, and the IMF estimate that investing during times of uncertainty actually gives you a greater bang for the pound, the euro, the buck invested, in terms of not just output but in terms of jobs, green jobs.
That’s the paradigm shift that’s required. You need to have the legislative and the regulatory changes that go alongside that. And then companies increasingly are facing regulators who are saying: you need to set out your net zero plan, your transition plan. You need to look at climate as a risk – is climate change going to be a risk to your business? If so, how do you mitigate against that? You need to make sure that your plans for the future are suitable. We tend to think of these businesses as reporting every quarter, but they all have strategic plans. Some of those transition will take time. For instance, warehouses that need upgrading, they need to consider that and finance it and help with the transition. Regulators are asking for reporting on it, and then shareholders can hold them accountable.
That’s the change that thankfully hasn’t been stymied by the pandemic. I would say in the last few years there’s been a lot of focus on ESG and bringing all the parts of society together in order to make concrete steps towards climate change.
Section four: Will climate cause the next crash?
Chris: That’s a very optimistic point. Now if I may drag us back to pessimism and the idea of crises again…! Mark Carney, amongst others, has been banging the drum about the potential need to dramatically reprice a lot of financial assets, purely because of climate. That’s sounds to me like a pretty classic cause of a financial crisis – a dramatic repricing of assets. Do you agree with him, do you think that this is something that we need to be worrying about?
An example might be the large amounts of property built within flood areas, because insurance companies are insuring what they really shouldn’t be if they made a rational calculation; but they realize they cannot just not renew the policy next year. Then it becomes the government’s problem, it becomes the state’s problem: what do you do with all these people? The impacts of climate upon everybody’s daily life and business is going to cause, to some degree or other, a financial shock to all of us.
Do you think that could be a cause of the next, or if not the next then a future, financial crisis?
Linda: I certainly think if the risk is large enough. Certainly on the point about insurance companies and areas which are prone to flooding, some insurance companies will step away from that and won’t insure that. But you’re absolutely right, and there’s been quite a lot of focus on areas, for instance in the US, where insurance companies continue to have a balance sheet which is at risk from dramatic changes in valuation because of climate change.
One of the things about having written a book about The Great Crashes is I think that climate, and this area which regulators call shadow banking (because clearly there are lots of different components of non-bank finance), I think these are all possibilities for the next crash. In my book I write about China because it’s just overdue for a crash. Forty years of nearly uninterrupted growth defies economic logic, so it’d be weird if China didn’t have one. But I make the point of saying that it may not be the next one – but when it has one, it will be a great crash.
In my previous book I wrote about JK Galbraith, the great economist, who said that economic forecasting exists to make astrology look respectable! But the point about climate risk on balance sheets, is I think why regulators are very keen that businesses take a look at their assets and price in the risk of climate, which is why I think the reporting requirements have changed. So it’s not just looking at how do you transition, and what are your milestones; it’s actually the valuation of what sits on your balance sheet. Have you properly priced in risk for climate change? It’s not just insurance; it’s also companies that operate warehouses, for example. Are they in potentially flooded areas? It’s companies that have goods in warehouses that could potentially flood, or companies that are house builders, and are building in areas which may actually be at risk of eroding.
All of those things I think could potentially trigger tensions. We certainly saw insurers coming into focus with AIG in the 2008 crisis. They were essentially rescued because they owned a lot of insurance on default for Lehman Brothers.
We also saw recently, liability-driven investment strategies for pension funds were caught out by the changes in interest rates. So again, all of that is not traditional banking, but increasingly is called shadow banking because there is a lot of potential risk around that sector. It may well be that that could be, if not the next, then a future crisis as you put it.
Chris: As part of the subtitle of the book – how we prevent them – are you suggesting that we are doing some of the right things and trying to prevent them by forcing companies to be looking at these and starting to be repricing them? Obviously if we took a big red pen and we tried to reprice everything in the morning, then there would have to be a financial crash. If, for example, you took Shell or BP and said, ‘all of your reserves, you can’t do them anymore,’ the economy would just collapse! That’s life.
But are you suggesting that the regulators are taking some of the right steps to say: you need to be looking at these issues and repricing them slowly over time so that, as it becomes more apparent that these issues are occurring, you’re more accurately priced?
Linda: The subtitle of the book is to hope that a crash doesn’t become a global meltdown. The subtitle is: lessons from global meltdowns and how to prevent them. But we will not prevent the next crisis. We will have another crash. We’ll have another crisis. The question is, can we limit the extensiveness of it so it doesn’t affect people’s livelihoods for years and years?
One of the ways regulators are focussed, and an area we haven’t discussed yet, is around fund management asset allocation. Investment companies obviously are the shareholders of lots of companies, so this is another part of the jigsaw – the financing community.
The reporting is on what your principal risks are, and then what are your emerging risks, and it is an ESG framework that’s put around it. So in this country – it’s different for different countries – but for the UK it is trying to say, what are the principal risks that your investments face? And then what are the emerging risks.
Businesses know their business best. However, especially if you’re looking at companies who’ve either been around for a long time, or startups, I think that’s where the financing community plays a role. They look at their own portfolio, engage with the companies and say, I think for your industry climate is more than an emerging risk – it’s a principal risk. But there may be other industries where the impact is over a longer period of time, and it may be more of an emerging risk.
There are different challenges. We’ve talked about flooding, but it could be biodiversity, the environmental challenges themselves appear in different ways. I think having companies look hard at how they operate their assets and at their balance sheets, the financing community can engage with them because they also can see, for instance, lots of companies in the same sector where they can see lessons from different sectors that can be brought to bear on a company. To say: how have you valued this? Have you properly looked at the risk around this? Is there any way you could change the way you operate to mitigate against it?
I would say that a number of startups may not have fully fledged ESG departments (because they’re startups!) but a lot of the startups are very focused on being sustainable, both in the environmental and the social sense. A lot of them are disruptive because they’re sustainable, because they are looking at their impact on society. I can think of companies who produce, say, footwear; but the way they produce it is environmentally sustainable and that is their USP, that’s their selling point. So to me, those companies also have the potential to disrupt traditional companies who may get a little complacent. That’s the other lesson from history that I write about my previous book: Kodak was offered a camera which didn’t use film, but they didn’t want to disrupt their existing market. To me this is all part of the paradigm change, which I’m glad to see has come out over the past few years
Section five: climate lessons from the great economists
Chris: Your previous book, The Great Economists, was fantastically successful which shows there is a lot of appetite and a lot of interest in the area. It pulled together 12 of the greatest economic thinkers; which of those economic thinkers would you think is most influential in the way we deal with climate as an economic incidence today?
Linda: I would say Robert Solow’s work on growth models. His work in the 1950s still forms the basis of what we call neoclassical growth models, on the basis of thinking about the economy being comprised of capital, labour and technology which can boost productivity.
That way of thinking about valuable assets – so for instance, capital could be green capital – if you fast forward to William Nordhaus, who won the Nobel Prize for incorporating environmental climate considerations into macro growth models, that’s the basis of how you can think about calculations of say, green GDP. What would growth be once you consider the impact on the on the environment?
All growth models have a degree of intertemporal quality – consumption tomorrow versus consumption today. Those have generated quite a lot of debate about what is the proper discount rate to use to have a sustainable planet in the future. How much do you really discount that today?
This offers the quantitative evidence that this is something that needs to change, in terms of the way in which society grows in a qualitatively improved way and not just quantitatively, which is how, traditionally, growth has been thought about. That’s where the idea of green GDP is interesting because that is a qualitative as well as just a quantitative. If you grow strongly, but you’re destroying the planet, how can you not consider that, given that natural capital is non-replaceable? Which means you would place a huge value on it and you wouldn’t discount that very much in thinking about your actions today.
So I think that whole stream has generated models, evidence, quantification and has helped stakeholders pushing the issue along.
Chris: In the environmental space, there is a lot of conversation going on about green growth versus degrowth. What do you think Solow would’ve thought about that debate, and the obvious tension between the two ideals?
Linda: When you grow in a qualitatively different way, economists have actually long discussed at the idea of utility. We think about firms as profit maximizing, but people are always thought about as utility maximizing. So what actually feeds into your utility function?
This is actually an idea that goes to philosophers like [John Stuart] Mill. All the early economists from that book, are actually philosophers – economics as a subject didn’t actually really exist until the turn of the 20th century when the Neoclassical economist Alfred Marshall created the term economics. Previously it was always called political economy, it was always philosophy. So the basis of Welfare Economics is that people maximize their utility, which is based on consumption of not just work, but also leisure and their quality of life. So it’s the qualitative-ness of the growth that I think has shifted in the way that we think about it.
There are lots of challenges around the slowing growth rate. So for instance, some economists would say that as our growth rate slows we really couldn’t afford to finance, say, the NHS or public services. That’s a big debate in aging societies like in Europe, and I think there is a whole set of issues to debate there. But I would step back and say, if you want to grow in a qualitatively different way that maximizes utility – enjoying the planet and enjoying the environment – then utility has a longstanding tradition in economics.
People make choices all the time based not just on money, but on lots of considerations. Society is made up of people making these decisions. So to me, that’s the change that we’ve also increasingly seen. We see it in the environmental space where people make choices. We talked briefly about working from home, and there’s a survey recently of US workers that essentially found that if your boss told you to come back to the office five days a week, only about two thirds would come back. About a third would come back and then secretly look for another job, and then the rest would just quit.
In The Great Crashes I write about how people’s behaviour has changed over the past few years. I think that would only strengthen their conviction in acting in ways that are environmentally sustainable as they go about their work; and companies are ultimately run by people.
Chris: Another of the big themes in the environmental world now, which you touch on your book through looking at Marshall, is inequality and the whole idea of environmental justice. How do we reshape the economy in a way that doesn’t increase injustice? What do you think Marshall would think about that concept, and how we can make that happen?
Linda: So Alfred Marshall was the Cambridge economist who essentially created the term economics. The change in thinking in the late Victorian period, seeing the deprivation caused by the crises of the late 19th century, laid the foundation for the welfare state. They realized that creating a social safety net didn’t disincentivize work. It just gave people security and help people who have fallen on hard times. So that parallel is when I write about The Great Reset, and one of the great resets is around a fairer society because inequality today in the United States, for instance, it’s being called the second Gilded Age. As the late Victorian period was in the UK, the same period in the US was called the Gilded Age, famously captured by F Scott Fitzgerald and other writers of the time.
The pandemic has actually showed that government can support incomes and support viable businesses in ways that support output and income in the economy, which is ultimately what GDP is. I write about the fact that inequality has been so severe and yet we see that in a time of crisis, by lifting especially the poor in society, we as a society are better off. I think it changes the perception just in the same way that happened a century ago. It didn’t disincentivize work; in fact, it saved viable businesses and it helped people who were in very challenging straits. So if you look now to the cost of living crisis, which I also write about, offering income support to help people with their energy bills, I see that as a product of the success of income support from the previous couple of years during the pandemic.
That changes the way we think about how support in any economy can help those who are least well off and how it benefits all of us as a society. There are also debates about universal basic income that I touch on in the book and ultimately we will settle on something I’m sure, in the same way they did a century ago. But I think people are now more open to the idea that having a focus on those who are least well off is beneficial for everyone, and I think that could make for a fairer and a greener society going forward.
Section six: Linda’s life advice: engage!
Chris: A fantastically optimistic way to finish!
One last question. I Always ask for a little bit of advice from our from our guests. In your case, I think what really struck me was quite how accomplished you are in so many things. Could you give some advice to people who might be feeling overwhelmed, or people who might think that they would like to be doing more with their life? What’s the secret of doing so much, so well?
Linda: Oh gosh, I’m not sure I’m in a position to offer advice!
I’ve always thought that as the quotation goes: chance favours the prepared mind. I’ve always thought that the more you enrich yourself, the more that you’re open to opportunities, the more you’re engaged with the world.
There are a lot of things that happen in life. I think just being prepared, being open, and I think staying curious and always wanting to learn. What made the great economists great is that they were always engaged with the big issues of the day. Even if it wasn’t easy, even if it was messy, even if it wasn’t quantitatively as neat as their models. I think is that degree of engagement, that’s what I mean by be curious, be open, which is to try and contribute in various ways.
And then also as we’ve discussed, I think utility maximization means people should value leisure. I think you should think about the qualitative ways in which you can grow as a person, not just quantitatively.
Despite having written a book on The Great Crashes and on The Great Economists, which actually went back to the 18th century, the amount of progress (with setbacks) that we have seen always makes me optimistic. We’ve seen challenges before, some of which have been horrific challenges, and we have come through it. I think it’s just keeping that long-term perspective, which might also help. So maybe know some history!
Chris: Thank you so much, Linda. That was wonderful.
Linda: Thank you!
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