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Humans are very much creatures of habit, repeating past mistakes, especially when greed is involved.
People forget that many generations of investors also have faced their own financial crises, making the latest crisis just one more in a chain of unfortunate events. This might be small comfort to those on the losing end, but it seems that investors, irrespective of which financial crisis they are facing, all pass through the same cycle of events.
The first phase starts with an innovation or discovery that creates new and profitable investment opportunities. Innovation can enhance existing financial products with new “add-ons” such as derivatives, or new discoveries in products and commodities can displace existing ones or introduce new varieties.
The second phase involves a credit boom, as investors fund these innovations, either from existing savings or credit borrowing, based on anticipated large returns.
Word of mouth and other forms of advertisement create wider awareness of the new investment opportunities, leading to a general sense of euphoria in the third phase and fueling overly optimistic expectations, which lead to rapid rises in asset prices.
Investors and dealers justify such price increases as being appropriate and “different this time” compared with other cycles.
These promises lead to the next phase of the financial crisis — mania, where the prospect of making easy money draws in speculators, leading to further price increases and, most worryingly, a loss of touch with basic business or economic fundamentals.
Who can forget the mania of the speculative share price bubble in the Saudi stock market during 2006 when the Tadawul index reached 21,000 and magically seemed to grow every week, encouraging many part-time employees, civil servants and students to become investment gamblers. The Tasi, or stock exchange index, ended the year at 7,933.
During this period, more than 4 million Saudis, many inexperienced in financial matters, invested in the stock market, prompted by rumors and so-called insider investment tips. Many lost their jobs and some needed counseling to cope with the mental strain.
Currently, the Tadawul index hovers around the 11,300 mark, far from the 2006 highs but still among the 10 top-performing capital markets in the world. The Tasi gained 30 percent in 2021, compared with first-placed Abu Dhabi with a 65 percent rise.
However, following on from such debacles comes the fifth stage — distress. Market sentiment shifts from greed to fear, and insiders cash out first, depressing prices and leading to the sixth stage — panic and a crash. A herd-like investor stampede to sell accelerates the price crash and leads to personal and business bankruptcies, especially if companies become leveraged to participate in the stock market and lose sight of their core business activity.
Stage seven is characterized by a general recession, as the disruption and costs of the financial crisis tips the economy into recession. This can be mild in some countries, or more severe, depending on the importance of the financial sector to the general economy.
The last, and probably most interesting, is the eighth stage, which is characterized by public recrimination and outrage that such a situation was allowed to happen. This is followed by hasty legislative and regulatory crackdown by the authorities in order to avoid such a crisis recurring. History reminds us what happened before and offers lessons, if one is willing to learn. Financial crises have a long pedigree, with examples from ancient history during Roman times, to the tulip mania in Amsterdam in the 1630s. Britain had the famous South Sea bubble of 1719, which arose from a bizarre scheme to privatize the country’s national debt. This was driven by insiders, who were the first to cash out, leading to legislation that hindered business evolution for many decades.
In more recent years, real estate lending was at the heart of the failure of about 1,400 US Savings and Loans companies, as well as 1,300 US commercial banks in 1984-91, after many of the S&L firms expanded hugely in the wake of deregulation. Banking crises hit other countries, including Denmark and Norway in 1987, and Sweden and Finland in 1991, due to a combination of financial deregulation and real estate lending.
Globalization in the 1980s led to a systemic banking crisis, especially in emerging markets. These included former communist countries of the 1990s, the so-called Asian “tiger economies” and others in 1997-98, Russia in 1998, and South America in 1998-2000. A common feature of many of these emerging crises was a sudden reduction of international capital inflows, triggering both a currency and a banking crisis.
And who can forget the 2007-2008 global financial crisis, which was mostly a European and US issue, based on seemingly irrational investment by banks, regulatory failures, and credit rating agency laxness in seeing through complicated bundled asset layers of varying credit worth?
A more recent financial crisis involving technological change and greed features Elizabeth Holmes, who launched Theranos in 2003 and at one stage valued the company at almost $9 billion. There was just one problem: Her miracle blood test technology was junk and few Silicon Valley investors asked the right questions. Theranos was another case of greed and pumping more air into asset bubbles.
Today, rapidly advancing shadow banking and cryptocurrencies pose new risks and regulatory headaches.
In conclusion, despite the lessons of past centuries, and the efforts of regulators, financial crises will reappear as long as that basic human element — greed — remains. So, please, stay calm and enjoy the current financial crisis. Until the next one.
• Dr. Mohamed Ramady is a former senior banker and professor of finance and economics at King Fahd University of Petroleum and Minerals in Dhahran.