Tuesday, November 11, 2008

The Panic of '08

I have been seeing more and more parallels between the current economic crisis and the "panics" of the 19th century. The main reason is international capital flows: For the first time since the Panic of 1907, a full 101 years ago, the movement of money in and out of the U.S. appears to have played a crucial role in the current economic situation. Even though we now have "fiat money," our system is showing aspects of the gold standard. Only now, it's not the presence of gold that matters, but the flows of money into the economy.

Before WWI, the U.S. was heavily dependent on British capital. London was an essential investor in most railroads and other major public works throughout the 19th century. Most of the economic crises of that period involved a disruption of that money, a lack of gold, or both:

The Panic of 1837 was partially caused by the Bank of England raising its interest rates to keep gold from flowing into the U.S. economy.

The Panic of 1857 was partially caused by British investors removing funds from U.S. banks after the failure of the Ohio Life Insurance & Trust Co. It was exacerbated when a ship carrying about 15 tons of gold sank off the NC coast.

The Panic of 1907 was the direct result of the collapse of the Knickerbocker Trust Co. But that bank failure was the final in a complex series of events, the most important of which was the Bank of England's raising its interest rate to 6% from 4%.

In each of these crises, events caused British investors to remove gold from the U.S. economy. Less gold meant less credit, which meant less economic growth. This is why countries used to raise interest rates to attract capital. In the old system, higher interest rates actually increased credit growth. (This was one of the reasons for the creation of the creation of a federal reserve of gold, a lender a last resort, that would support U.S. banks in case random events on the other side of the globe caused a withdrawal of gold.)

During WWI, the U.S. essentially paid off its debts, so was no longer dependent on foreign capital. All of the the following crises resulted from problems in the domestic economy, such as declines in production after wars or inflation.

Something different started happening in the late 1990s when foreigners started buying more and more U.S. credit products... essentially corporate bonds and various asset-backed securities (mortgage bonds). My other observation is that as the dollar appreciated against the yen, it provided a handy source of almost infinite cheap money that could be invested in higher-yielding assets. My contention is that by raising interest rates from 2004 to 2006, the Fed inadvertently stimulated credit growth by allowing market participants to engage in the "yen carry trade." (Rising U.S. rates made it easy to bet on the dollar versus the yen.)

Every dollar Ben Bernanke thought he was taking out of the economy, Goldman Sachs and all the other hedge fund shops rammed more dollars back in by borrowing in yen. This was like a huge giant free bank, and it was made possible by the Fed's rate hikes. Then there were SIVs and hedge funds that funded at Libor... Both essentially borrowed at short-term rates and invested in higher yielding assets such as asset-backed securities. As the Fed raised rates, borrowing costs rose for these market participants, causing them to seek every higher yielding assets to invest in. This had the perverse incentive of increasing risk appetite. Because they were short-term investors and not regulated as banks, they could essentially take almost any kind of credit risk. Raising rates on them didn't make them lend more parsimoniously -- it made them more reckless!

This reminds me of the situation in China, where their high interest rates caused "hot money" inflows. This increased the deposits in their banks, allowing more credit creation.

In our case, the money went into our capital markets, which thanks to securitization, had replaced banks and the ultimate providers of credit to the economy.

Now that we've built this system, we're stuck with it. In the early 1930s, one of the causes of the Great Depression was the Fed trying to turn back the clock and restore the gold standard. That just caused deflation and economic misery. This time, our complete neglect of the term debt market is having a similar effect. This is why I urge the government to start buying corporate bonds and asset-backed securities as quickly as possible. It's the only way to get credit back into the economy. Unfortunately, they be like the Fed in 1931, which emulated the Bank of England's 1907 rate hike. By then the gold standard was broken. This was Keynes's great observation.

This time, we still don't have a gold standard, but we are going back to something like it. Until we recognize that and embrace it, this economic crisis will continue to worsen.


It's like being the father of a 15-year old girl. One day she comes home pregnant. You can kick her out of the house, resulting in a nasty estrangement and perhaps major problems for both young mother and child. Or, you can embrace her and the new grandchild as family and your own flesh and blood -- intended or not.

Given the last 20 years of deregulation, globalization and securitization, this sick economy is now like our own 15-year old pregnant daughter. We can recognize that banks are no longer the ultimate providers of credit and embrace a capital-markets based system as we would embrace a new grandchild, or we can turn our back and lose a valuable part of ourselves. That means the time is now to intervene and support the term debt market. As I explain in this posting, messing about with the CP market won't work. The government needs to buy corporate bonds and asset-backed securities, or watch the stock market fall another 50%. (I see the S&P500 at 480 by the end of next year.)

Times change, and we must move on. We already know that the Fed's overnight lending facilities, etc, are incapable of fixing this. There is no going back. This weird capital-markets based economy is our new family. We cannot change reality by ignoring it.

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