Scarred by history

Sarah O Connor, echoing a point recently made by Minouche Shafik, fears that millennials have been frightened by the crisis into being too timid to push for better wages. I sympathize..

One of my favourite theories about the long post-war boom is that wage inflation was low in the 1950s despite full employment because workers remembered the Great Depression of the 1930s and so were too scared to exploit their bargaining power to demand higher wages. However, as those who remembered the 30s retired to be replaced by those who had only known full employment, wage militancy increased in the 60s and 70s.

It is, however, not just workers who can be cowed by memories of hard times. So too can be stock market investors. Ulrike Malmendier and Stefan Nagel have shown (pdf) that Americans who experienced recessions in their formative years hold fewer stocks and more cash than those who experienced better times even decades later. Other research (pdf) has found that much the same is true of Europeans. What’s more, those scarred by recessions tend to hold more value stocks and fewer growth ones.

In fact, it’s not just bad economic experiences that have a scarring effect on risk attitudes. Alessandro Bucciol and Luca Zarri have found that people who suffered the death of a child or natural disaster are also more risk averse years later.

All this is consistent with Hyman Minsky’s financial instability hypothesis (pdf) – the idea that economic stability is inherently destabilizing. Traders who have only known good times are likely to take on more risk, thus increasing financial fragility. And when the bust comes, it increases risk aversion thus giving us a period of financial stability which eventually increases appetite for risk. And so on.

Other research by Professor Malmendier corroborates this. She’s found that banks (pdf) that were under-capitalized and fragile many years ago operate today with higher capital buffers. Organizations can have memories as well as individuals.  

It’s not just financial investments that are affected by such scarring. So too are non-financial ones. Still more research by Professor Malmendier has found (pdf) that “CEOs who experience the Great Depression early in life display a heightened reluctance to access external capital markets.” I find it plausible that the 2008 crisis has increased firms’ desire to hold cash and dampened their willingness to invest.

The point here is a simple, if sometimes overlooked, one. “Animal spirits” matter. And they are determined not just by current events but also by quite distant ones. We are all creatures of history.

Comments

[Tom P]

Didn't Minsky say something similar about regulatory regimes? As in that their stance was informed by how recently they had experienced a crisis.

I wonder if that is the case this time around though. There has been a lot of lobbying from banks etc against regulatory "over reaction"

[Luis Enrique]

so we want bankers who experienced recent crisis to stay in their jobs as long as possible. People are very quick to assume the banks are heading for another crash already - I don't know about that, but I do know that risk only going to increase once they are staffed by clever young go-getters born in 2010

[Blissex]

«so we want bankers who experienced recent crisis to stay in their jobs as long as possible.»

As Minsky said of bankers "scarred" by the Continental Illinois and LTCM crisises and who stayed in their jobs, what they learned is that the government will always fill up their bonus pools again with lots of fresh free money, so they can continue their "capital decimation" asset stripping of their employers, forever.

A very funny quote from his 1986 "Stabilizing an unstable economy" paper:

«No matter how exalted a bank may have been, we all know that if assets were marked to market, the net worth of many of the giants of international banking would disapear. Nevertheless these banks are able to sell their liabilities in financial markets, because the buyers believe that they will be protected against losses by the central bank.»
«Formal deposit insurance, as introduced in the 1930's, is not responsible for this change. It can be demonstrated that if banks and other financial institutions were marked to market the claims on the reserves of the deposit insurance agencies would far exceed their resources. Deposit insurance is viable because it is supported by central bank and government commitments to validate the liabilities of protected institutions.»

As to path dependency ("scarring"), JR Galbraith expressed the concept very well already in 1954 in "The Great Crash 1924", page 25 of the Penguin edition:

«Just as Republican orators for a generation after Appomattox made use of the bloody shirt, so for a generation Democrats have been warning that to elect Republicans is to invite another disaster like that of 1929. The defeat of the Democratic candidate in 1952 was widely attributed to the unfortunate appearance at the polls of too many youths who knew only by hearsay of the horrors of those days. It would be good to know whether, indeed, we shall some day have another 1929.»

Funny eh? :-)

Indeed in the USA just about every time a Republican (or "centrist" Democrat) Congress has been elected there has been an excess of speculation leading to a crash.

[Blissex]

«There has been a lot of lobbying from banks etc against regulatory "over reaction"»

As usual such reports are a myth.

City bankers are *enthusiastic* about «regulatory "over reaction"» when it means the BoE and Treasury handing out to them hundreds of billions of no-strings-attached welfare money to protect their jobs and refill their bonus pools.

They only object to «regulatory "over reaction"» when it means limiting their opportunities to asset strip their own employers via high-leveraged fat-tail-risk-ignoring speculation.

[Ralph Musgrave]

Chris,

Re your 2nd para (memories of the 1930s etc) I quite agree. I’ve been saying that for years.

[Billy]

"Sarah O Connor, echoing a point recently made by Minouche Shafik, fears that millennials have been frightened by the crisis into being too timid to push for better wages."

Well they're certainly not too timid to bitch and moan about statues of historical figures at universities. When real life hits these poor lambs it'll hit hard.

[Luis Enrique]

Blissex,

well there's the moral hazard argument so beloved by right wingers who wanted to let everything crash and burn.

I recall some research showing that the idea bankers did what they did because they knew they'd get bailed out is nonsense - rather they did what they did because they had no idea it was going to destroy them.

IMHO whilst I am quite prepared to believe some bankers are cynical enough to line their pocket then walk away from the burning building, I would not be so quite to assume that the financial crisis is an experience bankers are in a hurry to repeat. Their shareholders certainly won't be.

[JRH]

@Luis Enrqiue:
"IMHO whilst I am quite prepared to believe some bankers are cynical enough to line their pocket then walk away from the burning building, I would not be so quite to assume that the financial crisis is an experience bankers are in a hurry to repeat."

Agree, also remember this stuf plays out at the personal level but corporate cultural level. So whilst good times (or at least non bad times) are around ther are very few organisations that will allow a chalenge o a practise that makes serious money for an organisation. Cassandras will be marginalised, lip service to risk will be given (not that it can be measured that well anyway) and so on it goes.