Opinion: Lessons from bubbles and busts

Frank G. Zarb, former chief executive of Nasdaq, is non-executive chairman of Promontory Financial Group. Anoop Rai is a professor of finance at Hofstra University and director of the Center for International Financial Services and Markets. They co-developed the MBA course "Financial Crises and Public Policy" with Sal Sodano.

The German philosopher Friedrich Hegel once said we learn from history that we never learn anything from history. The role of educators is to try our best to prove Hegel wrong.

The world's recent financial debacle shares many features of past fiscal crises, yet there were few business or political leaders who were able to connect the dots in a meaningful way. That failing presents an important opportunity for those of us who are training the next generation of leaders.

Business schools play a pivotal role in shaping the values of our future leaders. The management principles, strategic analyses and financial models developed and taught in business schools dominate real-world business practices. That means schools have an obligation to keep abreast of the constantly changing marketplace.

Past global crises and business failures have already caused business schools to modify their programs. The international bank and debt crisis of the 1980s added country risk and risk management components. The Enron and WorldCom scandals in the early 2000s brought about renewed calls to strengthen the ethics and sustainability perspectives in business courses. And, now, the Great Recession has brought into focus another missing component in business curriculum: understanding the history of financial bubbles, busts and associated public policy.

Economists, regulators, and investors continue to debate why the signals of the recent crises were for the most part missed. As Carmen Reinhart and Kenneth Rogoff show in their latest book, "This Time It Is Different: Eight Centuries of Financial Follies," there has been no dearth of financial bubbles in the past; we should be able to predict them. The last was only 20 years ago in Japan, if we ignore the dot-com bubble (which was not debt or finance-related).

Could a mandatory course in business school on the history of booms and busts have made a difference?

So Hofstra University decided to introduce a crisis-focused elective for MBA students majoring in finance. Offered for the first time this past semester, the goal of "Financial Crises and Public Policy" is to review the history of financial bubbles, identify common factors, and examine how government has played a role in both causing and mitigating bubbles.

We think adding a historical perspective on how, when and why financial bubbles and busts take place will make an eventual difference by enabling future market participants to recognize warning signs. A detailed look at the success and failure of public policy linked to financial crises could improve governmental action in the future, as some students enter public policy jobs. Students are asked to drill deeper than the media reports and congressional investigative theater, to probe the real conditions responsible for boom and bust.

Research on financial crises has long documented several factors that are common in the run-up: buoyant growth, excessive debt, lax regulation, the entry of naive investors, soaring real estate prices and overly optimistic groupthink. It's almost always true that even conservative market participants relax their risk standards.

Examining these factors, crisis by crisis on a historical timeline, provides a much better appreciation of the relevance of each issue and the danger it poses when all converge to form a perfect storm.

It's also critical for future business managers to learn about the importance of independent leadership in times of crisis. Some economists, investors and others sounded alarm bells before the recent crash, but only a few acted on them. Teaching students to think and act independently has to be balanced against the difficulties in bucking the trend and being labeled a naysayer when the whole world is riding the bubble.

Students also need to be exposed to the role of public policy in either abetting or properly responding to the financial crises. Since the savings and loan debacle of the 1980s and other banking scandals, there has been a steady increase in global regulation on financial institutions. By examining the inconsistent and diverse responses to crises in history, students realize that policy adapted to respond is often ideologically driven. Crises enable politicians to push through legislation that, while appropriate and effective sometimes, isn't at other times -- and often stays past its useful life.

If policies and regulations aren't carefully crafted, they can become a significant factor contributing to the problem. Just look, as our students do, at the Bubble Act of 1720, passed in the British Parliament to rein in bogus companies that had mushroomed all over London, peddling stocks in a period of stock mania. One of the favorite stocks was that of the South Sea Co., and there's evidence that the company encouraged legislation to keep away competition. The resulting law instead served as a trigger to bust the bubble, creating a downturn that lasted several years.

Students also need to learn that individuals, as well as regulations, can play a major role in preventing and managing crises. Alexander Hamilton's intervention in the financial markets by purchasing bonds and cajoling other lenders to inject liquidity into the system helped prevent the panic in 1792 from escalating into a recession. Similarly, J. Pierpont Morgan behaved like a one-man central bank to contain the panic of 1907 by arm-twisting other banks into supplying liquidity and keeping the markets open.

The lesson here -- so crucial for today's students and tomorrow's MBAs -- is that clearheaded, enlightened leadership can make a difference.

As we found after some very deep and thoughtful discussions in class during the semester, students are genuinely interested in making connections between the current crisis and those in the past. But we shouldn't allow the enthusiasm for a course like this to weaken once the economy recovers and memories of the crash fade away. If anything, this approach should become part of the required curriculum at Hofstra and in all MBA programs.

If all we do is succeed in making one student remember the factors before the next crisis -- helping him or her to make wise decisions -- it will be worth the time. To quote another philosopher, George Santayana, those who cannot remember the past are condemned to repeat it.