Predictability of Financial Crises: Lessons from Sweden for Other Countries

Fromlet, Hubert, Business Economics

The predictability of financial crises is widely regarded as low. However, skills linked to market psychology (behavioral finance) and the understanding of history and macrofinancial aggregates have been insufficiently integrated in the forecasting and risk management of financial institutions. Traditional financial modeling can no longer he applied as nicely as in the past. In Sweden, the financial crises of the early 1990s and in the latter part of the past decade were caused by overconfidence, control illusion, and herd mentality--hut also by shortcomings in management and corporate governance. There is no evidence that these two serious Swedish banking crises were not fireseeable. The general question is when and under which circumstances financial decision-makers and authorities should listen to the usual minority of warning voices. One conclusion is that economists should be more "in house-oriented," and top managers should heed their professional opinions. Conclusions from this paper can also be drawn for China, India, and other emerging markets both when it conies to financial deregulation policy and government debt risks in deregulated financial markets.

Business Economics (2012) 47, 262-272.

Keywords: Sweden, financial crisis, forecasting, behavioral finance

It is clear that there are few tasks for economists as compelling as the ability to predict the onset of a financial crisis. Clearly, nowadays central banks want to do this in order to set in motion the actions needed to avoid one. Moreover, if it appears that if a crisis is possible, banks, other financial institutions, and other private actors in the economy need to know of such an eventuality in order to plan and implement defensive measures. However, the predictability of financial crises is still widely regarded as low, particularly in academia and at central banks.

The position of this paper is that this belief can be challenged by enhancing skills that are linked to market psychology (behavioral finance) and the understanding of history and macrofinancial aggregates. These areas of financial market research have been insufficiently integrated into the forecasting and risk management of governmental and private financial institutions, as well as academia.

Using the Swedish financial crises of the early 1990s and the late 2000s, the paper demonstrates that it is time to accept that traditional financial modeling can no longer be applied as nicely as it has in the past. It has been obvious in Sweden that these crises were caused by overconfidence, control illusion, and herd mentality--but also by shortcomings in management and corporate governance. Section 1 of this paper describes the two Swedish crises and reaches conclusions related to the avoidance and correction of future crises. Section 2 describes the areas of research that must be pursued in order to understand risks and to avoid future crises. Sections 3 and 4 examine the predictability of the two Swedish crises, had the understanding described in Section 2 been applied. Section 5 describes general lessons that should be learned from the Swedish crises. Section 6 describes how developing countries, particularly China, can benefit from lessons learned in the wake of the Swedish crises. Finally, Section 7 looks at the predictability of future crises and the role of economists in averting them.

1. Two Swedish Financial Crises

The Great Swedish financial crisis of the early 1990s--Crisis 1

From the mid-1970s, when the consequences of the first big modern oil crisis were felt, until the mid-1990s, Sweden was characterized by significant deficits in national savings. During these two decades, there were only a few years in which the current account was roughly in equilibrium [Lindstrom and Lundberg 1993]. Several devaluations took place during the latter part of the 1970s and during the 1980s, accompanied by persistent inflation problems. (1) A major fall in the value of the Swedish krona also occurred after the transition of the krona to a floating exchange rate regime in late 1992.

In the 1980s, the Swedish economy was in horrible structural shape, caused by high government expenditure, enormous wage increases, and inflation; but it existed also in terms of poor regulations, weak competition, high subsidies, an inefficient structure of the labor market, wrong or lacking incentives on all levels, ineffective financial markets, and a harsh tax system. For example, marginal taxes for ordinary wage earners were as high as 60-65 percent. On the other hand, interest payments for private households were deductible in these high ranges. In combination with high inflation, this constellation meant, over many years, negative real interest rates for credits to consumers and homeowners. This situation favored the creation of enormous private debt--a situation that was not remedied until the implementation of a major income tax reform in 1990 and 1991 [Lybeck 1992].

From this point onward, interest rate deductibility in the tax bill has been reduced to 30 percent. Initially, this change was received as an income shock by most Swedish households, but households gradually have become used to it. Although the tax reform was badly needed, its initial shock came at the same time as the banking crisis was getting progressively worse. There was no real co-ordination of changes in economic policy by the public authorities involved.

In the 1980s, there was no real comprehensive financial market: daily trading of government and mortgage paper did not exist to any mentionable degree. At this time, reality focused on regulated credit and bond markets. By law, banks had to invest an important percentage of their deposits in government bonds and in the bonds of the mortgage institutes and banks. Insurance companies had strict investment rules that favorable bonds, too. Consequently, the government and the housing sector were in a favorable non-tradable investment position. Credit ceilings for the banks were considered to be a "normal" regulation. However, banks got around this by selling parts of their excess new loans to insurance companies overnight--just before the end of the month when the new credits were measured--and buying these loans back as soon as the new month had started. Thus, the credit ceilings were formally met--one of the most serious loopholes in the Swedish credit market. Therefore, nobody was surprised when the credit ceilings imposed by the Riksbank (the Swedish central bank) were finally scrapped on November 21, 1985. From this day onward, a fast credit expansion started, which ended with the bursting real estate bubble in 1990 and 1991.

Another phenomenon contributed to the origins of the Swedish financial crisis of the early 1990s. Until 1989, Swedes and Swedish institutions were virtually banned from investing in foreign stocks, bonds, and real estate. There were some minor exceptions, but these were not of any economic significance. Suddenly, these cross-border activities were made possible. This happened in a period of an ongoing fast credit expansion. This could not be regarded as an optimal timing.

Large numbers of Swedish real estate investors went directly to London, Paris, …

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Publication information: Article title: Predictability of Financial Crises: Lessons from Sweden for Other Countries. Contributors: Fromlet, Hubert - Author. Journal title: Business Economics. Volume: 47. Issue: 4 Publication date: October 2012. Page number: 262+. © 1999 The National Association of Business Economists. COPYRIGHT 2012 Gale Group.

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