On Manias, panics and bailouts further thoughts on the financial crisis
( Jan.14, 2009, This is a paper that I submitted to The Economists' Voice early last fall .The original version was e mailed there on October 3rd,2008.It reflects developments as of then. At the time when I was suggesting a 500 billion dollar stimulus might be necessary as far as I am aware virtually no analyst other than perhaps Nouriel Roubini was speaking or writing of the need for such a large stimulus package.
The electronic journal chose not to publish it but I think it deserves to be read because of the analysis it contains and when it was written.Obviously we have now moved beyond this essay particularly with respect to TARP and its failure so far to successfully unlock the US financial markets and to transparently account for the monies transferred to the banks and Wall street firms. Now that Obama is installed I hope that this will change.His close to 800 billion stimulus package passed into law by congress is a major step in the right direction.
The current economic environment continues to signal widespread bearishness, falling prices in producer goods and commodities including energy and rising unemployment.The US producer price index fell 1.9 % in December, 08 the fifth consecutive monthly drop.The price of finished goods fell 0.9 % compared to rising 6.7 % in 2007.energy prices also fell 9.3 %. U.S. unemployment has now risen to 8.1 % and looks like it will peak over 10 % in the coming months. There are emerging financial crises in Europe because of the Western banks' exposure to what are now bad Eastern European loans, the Russian oligarchs are in big trouble and will require bailing out by the Kremlin and the Chinese economy is undergoing dramtic job losses.[See the New York Times March 7, 2009 Andrew Kramer, `"The Last Days of the Russian Oligarchs" and Laquat Ahamed, "Subprime Europe"]
The Dow Jones this past week fell below 6700 which is a huge greater than 52 % drop from its original high point of over 14,164 less than two years ago.Additional Ponzi schemes have been uncovered to add to the misery.Growth in the last quarter of 2008 fell by 3.4 % in Canada, over 6 % in the U.S. 5.9 % in Europe and over 12 % in Japan. )
On manias, mass panics and bailouts: further thoughts on the Financial crisis.
by Harold Chorney
Joseph Stiglitz ,the Nobel prize winning economist who teaches at Columbia university, along with millions of his fellow Americans, has been sharply critical of the original form of US Treasury Secretary Paulson’s bailout plan. Undoubtedly his critique contributed to changes in the Bill which improved it considerably although I am sure he is still somewhat critical of what has now been signed into law. He was quite correct to insist that taxpayers’ interests needed to be better protected in a process which involved transferring toxic assets from private to public liabilities.
One of the ways that the final version of the Bill attempted to accomplish this was by approving in principle the notion of reverse auctions of the assets to be bought by the Treasury and provision for the Government to receive warrants exchangeable for equity in the firms that participate in selling assets to the Treasury. Hence, if the firm profits from the improvement in its balance sheet the taxpayer will as well. Some critics argued that these reverse auctions would be extremely difficult to conduct because of the heterogeneity of the assets involved and the difficulty in establishing their value. But so long as there was no collusion among the sellers of the assets the reverse auction process should have resulted in appropriate prices for the assets given the distressed state of the sellers.(Klemperer)
One of the risks in the Bill, however , was the provision for the alternative of firms purchasing Government sponsored insurance for their assets at rates that would cover the actuarial cost involved. To the extent that it was actually taken up it would have increased the average toxicity of the assets that were left over and instead sold to the Treasury.
Slough off the really bad stuff to the Government and insure the rest for a profit. Hence the provision for receiving equity was critical to protecting the public interest. The provision in the Bill for the Government and Congress to assess the program’s implementation after five years of operation and then to levy taxes on the financial services industry to cover shortfalls in the full recovery of costs should also go some way to further protect the taxpayers’ interests (see section 134 `Recoupment`` Emergency Economic stabilization Act 2008).
Recent events however have overtaken the Bill.
Over the three weeks (October 2- October 25)the collapse in stock markets became a frightening global phenomenon. On Friday October 24 th the markets dropped world wide by over 316 points in the US Dow Jones, by 9.6 % in the Nikkei index in Japan and by 4-5 % in Europe and substantially in China as well. The Dow Jones had fallen from its peak of 14,164 a year ago this October 10th to just over 8300, a fall of over 40 %-- one of the larger drops in its history. Only the drops in 1919-1921, 1929-1932, 1937-38, 1939-1942, 1973-1974 are greater. The S and P 500 index in fact has suffered the second biggest slide in its history also falling by more than 42 %. The NASDAQ has fallen by 44.7 % over the past year and the Russell 2000 by 42.6 %.
Indices all over the world are down by between 33 and 71 %. These include Canada -32.8 %; Brazil-50.7; Mexico -42.5; Euro zone - 48.3; Switzerland -33.1; U.K. -39.9; Russia –71.1; Australia -39.0; China -65.8 Hong Kong -54.6; Japan -50.0 ; Singapore -53.8; South Korea -50.5; Taiwan -46.2. From October 26 to November 13th the market has fluctuated wildly culminating on November 13 th with a swing of 900 points in one day from a new bottom of about 7800 on the DOW to a close of just over 8800.The very next day however the market opened with a downturn suggesting that volatility and a sense of no clear direction remained the key characteristic as more bad economic news was released with deepening recessions in the U.K., Germany and the U.S. leading the way.
Oil has also fallen from its year ago cash spot price of 91.87 to a low of about $54 for West Texas Intermediate on the cash spot market. On the futures market it had peaked at $147 but it has now fallen to $56 on NYMEX.( Its January 2009 price so far is as low as $37.)
OPEC has cut its production quota once and it may do so again but it is quite possible oil will breach the $50 barrier despite this. Almost all of the other leading commodities have also fallen in price including copper, aluminum, platimum, lead, steel, tin , zinc coffee, wheat, corn , sugar, cheese , milk, corn oil and soybean oil.
Over the past 118 years there have been 100 episodes in which the Dow lost 10 % or more over the highest previous close in the previous 30 days. Of these, in 45 cases the Dow was higher three months later. In a number of cases there were longish bear markets that followed and in three cases 1907, 1929 and 1973 these depressed markets lasted several years . The August 1929 peak was only regained in November 1954.(Niederhoffer, pp.42-43)The 1973 peak in 1979 and the 1907 peak in 1910.
Markets world wide have experienced similar dramatic losses and the paralysis of the banking sector had worsened despite passage of the Bill. To combat this the Treasury has now implemented the provisions of the Bill which permit taking share ownership in return for injecting new capital. In this respect they have been influenced by the approach of the British Labour government led by George Brown which announced it was injecting 37 billion pounds into RBS, Lloyds and HBOS in return for equity in order to prevent their collapse.(New York Times , October 8, Guardian October 13,2008). In return the Banks have agreed to help prevent foreclosures and executives have agreed to limitations on bonuses and compensation packages. The British government will end up owning 43.5 % of the Lloyds HBOS group and 60 % of the RBS. It also is making 6.5 billion pounds available to Barclays should they decide to take it up.
George Soros also had suggested a variant of the British plan in an article in the Financial Times(October 12, 2008) which involved injecting both public and private capital into the banks in return for preferred shares. These measures will, of course, dilute the current shareholders’ common stock and entail further losses but in the longer run will help rescue the banks from collapse. At the same time European leaders announced that were going to guarantee inter bank lending in what should eventually be a successful effort to unlock the credit markets. Germany has set aside 80 billion euros to recapitalise its banks and France 40 billion euros. In addition the European central bank, the Bank of England and the Swiss central bank have offered their commercial banks unlimited swap loans of varying maturities and large quantities denominated in dollars in exchange for appropriate assets. All of these measures introduce substantial new liquidity into the financial system. If one totals up the European programs the total money involved is close to 2 trillion US dollars.
The US under the TARP is injecting up to $ 250 billion into American banks with the largest 8 banks receiving a total of $ 125 billion. The banks will receive the capital and the Government will take preferred shares in exchange and will guarantee senior debt for 3 years. The FDIC will insure all non interest bearing accounts which are primarily used by business. The biggest banks will apparently receive the money as follows: Bank of America $25 billion; Citigroup 25 billion; JP Morgan Chase 25 billion; Wells Fargo 25 billion; Goldman Sachs 10 billion; Morgan Stanley 10 billion; Bank of New York 2-3 billion; and State Street 2-3 billion.
The American and British action would in fact represent a partial temporary nationalization of banks and it would make it easier to unlock the credit markets and restore the proper functioning of the banking system . None of the governments is willing to say that their actions constitute nationalization but in fact that is what they are doing, albeit temporarily in an emergency. The British government has stated it has no intention of hanging on to the Banks for long but time will tell. It also reveals just how serious the crisis has become. The American action will also be time limited with the clear intention of returning the banks to private ownership as soon as conditions have stabilized and the Government can recover its investments.
The problem for the moment appears to still be despite these massive infusions of cash that no one trusts anyone else as to their counter party risk exposure. As a consequence the banks appear to be using the infusions not to unblock the credit and loan system but rather hoarding the cash possibly for takeover acquisitions while tightening credit to reflect the current head for the hills market sentiment. This is not good news and will require further intervention by the American Government and governments in other countries facing similar problems to insist that the banks use the money for the purposes intended.
In effect we have the outcome that Keynes foresaw in the Treatise on Money in his chapter on fluctuations in the rate of investment and his earlier discussion of the role of liquid capital (pp.116 ff vol2 &pp.59ff) in which he argued that disproportionalities in the savings and investment functions would lead to co-ordination problems in the economy and that excessive liquidity preference by the banks themselves could lead to inadequate investment and too high a rate of interest prevailing in inter-bank lending during a slump. (Keynes, Treatise, p.182 vol.2; See also the discussion of this in A.Leijonhufvud, 2008)This is precisely the situation we now face and the great challenge will be to get the banks to lend again at reasonable rates of interest.
In fact, as of November 13th the Treasury Secretary Henry Paulson announced that he was abandoning his plan to acquire toxic assets from the banks and instead was shifting his focus to use TARP funds to inject capital into the asset backed commercial paper markets that are linked to car loans, student loans and credit card debt. The government also announced on November 9th that it was increasing its injection of funds into AIG insurance by some $ 40 billion in order to reduce the burden of interest on previous loans to the company. The government has now injected some $152 billion into AIG through a combination of low interest loans, purchase of preferred shares and the establishment of a funded entity to offload and resell bad debt.
Great Britain has already ordered that its banks use the funds advanced to them to unlock their credit markets. It would be sensible for the US to do so as well. Paulson’s decision to refocus his attention on the non bank consumer oriented financial markets is a way of putting pressure on the banks to do so. By having refused to do so despite the advances made to them the banks will now have to accept lower prices for their toxic debt than what they would have been able to wring from the Treasury and their bargaining power is now reduced.(New York Times, October 25, 2008 When will the banks start making loans? ) Despite all these measures the indicators still point to falling prices, failing firms and increasing job layoffs.
It is of course one of the structural weaknesses of monetary policy pointed out by Keynes and admitted to by D.H.Robertson that `the banking system may be hard put to make the money supply large enough, and keep it moving fast enough , to check the fall in prices ” in a crash or depression. (D.H.Robertson, Money, p.177) That is why in addition to these financial infusions there is a need for additional fiscal stimulus.
Nationalizing banks, even partially and temporarily still takes us back to the days of FDR. It is a long way from rational markets theory and the philosophy of laissez-faire. There is no going back in the near future or even medium term to the economics of deregulation and laissez-faire capitalism after this. No less a free markets advocate than Alan Greenspan has admitted that his deregulation ideology was flawed and that he was shocked and in a state of disbelief by the failure of banks and financial institutions to properly self regulate the derivatives market and protect shareholders’ interests. (House testimony) No one for many years to come will be able to credibly argue for deregulation of the financial markets and laissez-faire knows best after these cataclysmic and paradigm shifting events.
Instead of rational markets we were confronted with a global market crash and a financial system that was perilously close to complete paralysis and failure. One of my colleagues has suggested that the markets did behave rationally by panicking and seeking to sell off equities that it viewed as horribly overvalued because of their exposure to the derivatives fiasco.
But this is disingenuous because of the origins of the derivatives crisis itself in the absence of market regulation. Laissez-faire obsession accompanied by excessive greed played a major role in unleashing this crisis.
But whatever its origins it has developed very swiftly into a once or twice in a century financial panic along the lines of the 1873 banking panic that was also based on a housing bubble, the 1907 collapse that was rescued by the joint intervention of the Government and J.P.Morgan and the collapse of the markets in 1929 and 1930 which ushered in the Great Depression. Some analysts on the left, such as, for example, Dean Baker(see the Guardian, October 3, 2008) as well as some on the right had insisted that President Bush, Hank Paulson and Ben Bernanke the Chairman of the Federal Reserve, who have warned of the risk of this crisis being as grave, were exaggerating the problem in order to advance their own special interests or agenda .
Current events in the markets suggest otherwise. Prominent market analysts like George Soros, Robert Schiller and Warren Buffett have been suggesting the possibility of an event of this magnitude long before President Bush spoke of it. Hyman Minsky suggested that it was a possibility two decades ago. The freezing up of the inter-bank loan market and the withdrawal of funds from the stock markets was already underway before President Bush warned of dire consequences .
Anyone who has studied or carefully observed the behaviour of mass society in the post-modern age knows that panics, crashes and irrational manias are an integral part of contemporary culture. Kindleberger, Minsky and Galbraith have shown in their own work just how powerful these kinds of destructive forces were in the past. There is not much of a leap from tulip bulbs, the South Sea bubble John Law and Mississippi swamp land to grossly inflated land values and overpriced cottages and houses and arcane derivatives that exploit lack of transparency to mask fraudulent overleveraged pricing. The irrational aspect of human nature and tendency to panic is a constant.
This aspect of human nature has been magnified and accelerated in the contemporary world. As John Koning a Toronto economist and investment dealer who writes from an Austrian perspective has pointed out the panics of the past are incorporated into the collective memory and they hence make it more likely for mass psychology to follow a familiar pattern.(See also Niederhoffer,McKay and Kindleberger) In the post modern world of click and blackberry culture and fleeting attention spans that typifies our world it is not a surprise to witness a financial panic that accelerates at a fearsome pace. An updated and effective regulatory framework will need to keep this in mind.
It will take time and considerable effort on a broad range of fronts to re-establish some stability and the absence of panic.
The immediate priority of the new Obama Government in Washington next January will have to be a reassessment of the legislation to fix whatever gaps still exist in it; a restructuring of the American auto industry; a massive fiscal stimulus perhaps as much as $500 billion that targets neglected infrastructure and creating jobs for low and moderate income people; programs to aid the poor, the homeless and those who are facing unemployment; repair and reform of the health care system to bring it up to a modern standard for an advanced capitalist country; and aid along the line that Stiglitz proposes for those who are facing foreclosure. The last is partly mandated by the Bill that has just been passed but undoubtedly will need improvement.
Here one can use a housing stabilization fund (HSF)or relevant portions of the TARP that relieves burdened homeowners of part of the mortgage and renegotiates the terms so that the liability for the relieved portion is shared between the original mortgagee and the HSF. In return for this aid the homeowner assigns an appropriate portion of any future capital gain to the HSF. I first developed a scheme like this more than thirty years ago when I was a government housing economist in Manitoba and was tasked with developing a scheme to prevent the benefits of a government land assembly from being totally captured by the first buyer of the property as opposed to being passed on to future buyers in perpetuity.(see my blog haroldchorneypoliticaleconomist.piczo.com April 7, 2008)Soros and others have proposed variants of this scheme in recent articles.
Although the deficit is being increased by these measures it is important to keep things in historical perspective. A one trillion dollar increase in the deficit adds about seven percentage points to the deficit to GDP ratio. So if a $500 billion fiscal stimulus were added to, say, a $500 billion dollar capital injection and the rescue of some toxic assets over the next two years(I am assuming that some assets will be insured rather than bought by TARP. Some will also be bought by private market actors. Some will also turn profitable over time) on top of about $300 billion for Freddie Mac, Fannie Mae and Bear Stearns and AIG the resulting deficit to GDP ratio would be significant , above 10 % of the GDP. During the Second World War the deficit soared to as high as 30 % of the GDP in 1943. It was above 20 % in 1944 and 1945.
At the moment financing costs are very low because of the enormous demand for quality government debt. The proportion of the debt held by the Fed is low, about 6 % as a proportion of the GDP as compared to 10.7 % in 1946.With careful management by the Federal Reserve including its intervening to keep the financing costs minimal through the purchase and resale of these assets there is no reason for the increase in the debt to cause any sort of alarm.
In 2006 the net debt (that is gross debt minus debt held by Federal Government accounts) to GDP ratio for the US was quite manageable, under 38 % of the GDP. (See Table 7.1 in The budget for fiscal year 2008, pp126-127.)
Even after expanding it to accomplish these goals it will still be very manageable, close to 50 % of the GDP.
As calm gradually returns to American and global financial markets which will take some time, the harrowing events of this past year will enter the history books as another powerful example of the limits of laissez faire and the necessity of countervailing regulation and a progressive state that uses Keynes style technique in order to bring humanist reason to bear on the extraordinary destructive but also potentially extraordinary creative power of advanced capitalism in the age of globalization.
References and Further Reading
New York Times, September, October and November 2008 daily issues.
Wall Street Journal, September, October ,and November 2008 daily issues.
Financial Times, September, October, and November daily issues.
HR1424 Emergency Economic Stabilization Act 2008
Dean Baker, “A crisis made in the Oval Office: A financial panic provoked by President Bush was designed to stampede the Congress into passing the bailout for Wall Street , ”October 3, 2008 www.guardianco.uk/commentisfree/cifamerica/2008/oct/03US.bush.financialcrisis/
Ron Chernow, The House of Morgan: An American Banking dynasty and the Rise of modern finance
Harold Chorney, www.piczo.com. haroldchorneypoliticaleconomist
Harold Chorney, “Debts, Deficits and Full Employment ” in R.Boyer&D.Drache, States against Markets:The Limits of Globalization, N.Y. Routledge, 1996
Simon &Schuster, N.Y.1990
Robert Bruner&Sean Carr, The Panic of 1907, N.Y. John Wiley, 2007.
John Kenneth Galbraith, The Great Crash, N.Y. Houghton Mifflin, 1954,
John Maynard Keynes, The Treatise on Money, vol.2 London: Macmillan vol.6 of Collected Works, 1930.
Paul Klemperer, Auction Theory: A guide to the Literature Journal of Economic Surveys vol. 13(3) www.nuff.ox.ac.uk/users/Klemperer/survey.pdf
Charles Kindleberger, Manias, Panics and crashes, N.Y. Harper, 1978.
Axel Leijonhufvud, Keynes and the Crisis Policy Insights, May 2008, Vol.23.
Axel Leijonhufvud & Brian Snowdon Snowdon interviews Leijonhufvud, www-ceel.economica.unitd.it/staffleijonhufvud/interview.pdf 2002.
Charles Mackay, Extraordinary Popular delusions and the Madness of Crowds, N.Y. Harmony Books, 1841, 1980.
Hyman Minsky, Stabilizing an Unstable Economy, New Haven, Yale University press, 1986
Victor Niederhoffer, The Education of a Speculator, N.Y. John Wiley, 1997.
Historical Tables: Budget of the US government, fiscal Year 2008
Kevin Phillips Bad Money: reckless finance, Failed Politics and the Global Crisis of American Capitalism
D.H.Robertson, Money, Cambridge, Cambridge University Press, 1946.
George Soros, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means
Harold Chorney
Professor
Political Economy and Public Policy
Concordia University, Montréal
The electronic journal chose not to publish it but I think it deserves to be read because of the analysis it contains and when it was written.Obviously we have now moved beyond this essay particularly with respect to TARP and its failure so far to successfully unlock the US financial markets and to transparently account for the monies transferred to the banks and Wall street firms. Now that Obama is installed I hope that this will change.His close to 800 billion stimulus package passed into law by congress is a major step in the right direction.
The current economic environment continues to signal widespread bearishness, falling prices in producer goods and commodities including energy and rising unemployment.The US producer price index fell 1.9 % in December, 08 the fifth consecutive monthly drop.The price of finished goods fell 0.9 % compared to rising 6.7 % in 2007.energy prices also fell 9.3 %. U.S. unemployment has now risen to 8.1 % and looks like it will peak over 10 % in the coming months. There are emerging financial crises in Europe because of the Western banks' exposure to what are now bad Eastern European loans, the Russian oligarchs are in big trouble and will require bailing out by the Kremlin and the Chinese economy is undergoing dramtic job losses.[See the New York Times March 7, 2009 Andrew Kramer, `"The Last Days of the Russian Oligarchs" and Laquat Ahamed, "Subprime Europe"]
The Dow Jones this past week fell below 6700 which is a huge greater than 52 % drop from its original high point of over 14,164 less than two years ago.Additional Ponzi schemes have been uncovered to add to the misery.Growth in the last quarter of 2008 fell by 3.4 % in Canada, over 6 % in the U.S. 5.9 % in Europe and over 12 % in Japan. )
On manias, mass panics and bailouts: further thoughts on the Financial crisis.
by Harold Chorney
Joseph Stiglitz ,the Nobel prize winning economist who teaches at Columbia university, along with millions of his fellow Americans, has been sharply critical of the original form of US Treasury Secretary Paulson’s bailout plan. Undoubtedly his critique contributed to changes in the Bill which improved it considerably although I am sure he is still somewhat critical of what has now been signed into law. He was quite correct to insist that taxpayers’ interests needed to be better protected in a process which involved transferring toxic assets from private to public liabilities.
One of the ways that the final version of the Bill attempted to accomplish this was by approving in principle the notion of reverse auctions of the assets to be bought by the Treasury and provision for the Government to receive warrants exchangeable for equity in the firms that participate in selling assets to the Treasury. Hence, if the firm profits from the improvement in its balance sheet the taxpayer will as well. Some critics argued that these reverse auctions would be extremely difficult to conduct because of the heterogeneity of the assets involved and the difficulty in establishing their value. But so long as there was no collusion among the sellers of the assets the reverse auction process should have resulted in appropriate prices for the assets given the distressed state of the sellers.(Klemperer)
One of the risks in the Bill, however , was the provision for the alternative of firms purchasing Government sponsored insurance for their assets at rates that would cover the actuarial cost involved. To the extent that it was actually taken up it would have increased the average toxicity of the assets that were left over and instead sold to the Treasury.
Slough off the really bad stuff to the Government and insure the rest for a profit. Hence the provision for receiving equity was critical to protecting the public interest. The provision in the Bill for the Government and Congress to assess the program’s implementation after five years of operation and then to levy taxes on the financial services industry to cover shortfalls in the full recovery of costs should also go some way to further protect the taxpayers’ interests (see section 134 `Recoupment`` Emergency Economic stabilization Act 2008).
Recent events however have overtaken the Bill.
Over the three weeks (October 2- October 25)the collapse in stock markets became a frightening global phenomenon. On Friday October 24 th the markets dropped world wide by over 316 points in the US Dow Jones, by 9.6 % in the Nikkei index in Japan and by 4-5 % in Europe and substantially in China as well. The Dow Jones had fallen from its peak of 14,164 a year ago this October 10th to just over 8300, a fall of over 40 %-- one of the larger drops in its history. Only the drops in 1919-1921, 1929-1932, 1937-38, 1939-1942, 1973-1974 are greater. The S and P 500 index in fact has suffered the second biggest slide in its history also falling by more than 42 %. The NASDAQ has fallen by 44.7 % over the past year and the Russell 2000 by 42.6 %.
Indices all over the world are down by between 33 and 71 %. These include Canada -32.8 %; Brazil-50.7; Mexico -42.5; Euro zone - 48.3; Switzerland -33.1; U.K. -39.9; Russia –71.1; Australia -39.0; China -65.8 Hong Kong -54.6; Japan -50.0 ; Singapore -53.8; South Korea -50.5; Taiwan -46.2. From October 26 to November 13th the market has fluctuated wildly culminating on November 13 th with a swing of 900 points in one day from a new bottom of about 7800 on the DOW to a close of just over 8800.The very next day however the market opened with a downturn suggesting that volatility and a sense of no clear direction remained the key characteristic as more bad economic news was released with deepening recessions in the U.K., Germany and the U.S. leading the way.
Oil has also fallen from its year ago cash spot price of 91.87 to a low of about $54 for West Texas Intermediate on the cash spot market. On the futures market it had peaked at $147 but it has now fallen to $56 on NYMEX.( Its January 2009 price so far is as low as $37.)
OPEC has cut its production quota once and it may do so again but it is quite possible oil will breach the $50 barrier despite this. Almost all of the other leading commodities have also fallen in price including copper, aluminum, platimum, lead, steel, tin , zinc coffee, wheat, corn , sugar, cheese , milk, corn oil and soybean oil.
Over the past 118 years there have been 100 episodes in which the Dow lost 10 % or more over the highest previous close in the previous 30 days. Of these, in 45 cases the Dow was higher three months later. In a number of cases there were longish bear markets that followed and in three cases 1907, 1929 and 1973 these depressed markets lasted several years . The August 1929 peak was only regained in November 1954.(Niederhoffer, pp.42-43)The 1973 peak in 1979 and the 1907 peak in 1910.
Markets world wide have experienced similar dramatic losses and the paralysis of the banking sector had worsened despite passage of the Bill. To combat this the Treasury has now implemented the provisions of the Bill which permit taking share ownership in return for injecting new capital. In this respect they have been influenced by the approach of the British Labour government led by George Brown which announced it was injecting 37 billion pounds into RBS, Lloyds and HBOS in return for equity in order to prevent their collapse.(New York Times , October 8, Guardian October 13,2008). In return the Banks have agreed to help prevent foreclosures and executives have agreed to limitations on bonuses and compensation packages. The British government will end up owning 43.5 % of the Lloyds HBOS group and 60 % of the RBS. It also is making 6.5 billion pounds available to Barclays should they decide to take it up.
George Soros also had suggested a variant of the British plan in an article in the Financial Times(October 12, 2008) which involved injecting both public and private capital into the banks in return for preferred shares. These measures will, of course, dilute the current shareholders’ common stock and entail further losses but in the longer run will help rescue the banks from collapse. At the same time European leaders announced that were going to guarantee inter bank lending in what should eventually be a successful effort to unlock the credit markets. Germany has set aside 80 billion euros to recapitalise its banks and France 40 billion euros. In addition the European central bank, the Bank of England and the Swiss central bank have offered their commercial banks unlimited swap loans of varying maturities and large quantities denominated in dollars in exchange for appropriate assets. All of these measures introduce substantial new liquidity into the financial system. If one totals up the European programs the total money involved is close to 2 trillion US dollars.
The US under the TARP is injecting up to $ 250 billion into American banks with the largest 8 banks receiving a total of $ 125 billion. The banks will receive the capital and the Government will take preferred shares in exchange and will guarantee senior debt for 3 years. The FDIC will insure all non interest bearing accounts which are primarily used by business. The biggest banks will apparently receive the money as follows: Bank of America $25 billion; Citigroup 25 billion; JP Morgan Chase 25 billion; Wells Fargo 25 billion; Goldman Sachs 10 billion; Morgan Stanley 10 billion; Bank of New York 2-3 billion; and State Street 2-3 billion.
The American and British action would in fact represent a partial temporary nationalization of banks and it would make it easier to unlock the credit markets and restore the proper functioning of the banking system . None of the governments is willing to say that their actions constitute nationalization but in fact that is what they are doing, albeit temporarily in an emergency. The British government has stated it has no intention of hanging on to the Banks for long but time will tell. It also reveals just how serious the crisis has become. The American action will also be time limited with the clear intention of returning the banks to private ownership as soon as conditions have stabilized and the Government can recover its investments.
The problem for the moment appears to still be despite these massive infusions of cash that no one trusts anyone else as to their counter party risk exposure. As a consequence the banks appear to be using the infusions not to unblock the credit and loan system but rather hoarding the cash possibly for takeover acquisitions while tightening credit to reflect the current head for the hills market sentiment. This is not good news and will require further intervention by the American Government and governments in other countries facing similar problems to insist that the banks use the money for the purposes intended.
In effect we have the outcome that Keynes foresaw in the Treatise on Money in his chapter on fluctuations in the rate of investment and his earlier discussion of the role of liquid capital (pp.116 ff vol2 &pp.59ff) in which he argued that disproportionalities in the savings and investment functions would lead to co-ordination problems in the economy and that excessive liquidity preference by the banks themselves could lead to inadequate investment and too high a rate of interest prevailing in inter-bank lending during a slump. (Keynes, Treatise, p.182 vol.2; See also the discussion of this in A.Leijonhufvud, 2008)This is precisely the situation we now face and the great challenge will be to get the banks to lend again at reasonable rates of interest.
In fact, as of November 13th the Treasury Secretary Henry Paulson announced that he was abandoning his plan to acquire toxic assets from the banks and instead was shifting his focus to use TARP funds to inject capital into the asset backed commercial paper markets that are linked to car loans, student loans and credit card debt. The government also announced on November 9th that it was increasing its injection of funds into AIG insurance by some $ 40 billion in order to reduce the burden of interest on previous loans to the company. The government has now injected some $152 billion into AIG through a combination of low interest loans, purchase of preferred shares and the establishment of a funded entity to offload and resell bad debt.
Great Britain has already ordered that its banks use the funds advanced to them to unlock their credit markets. It would be sensible for the US to do so as well. Paulson’s decision to refocus his attention on the non bank consumer oriented financial markets is a way of putting pressure on the banks to do so. By having refused to do so despite the advances made to them the banks will now have to accept lower prices for their toxic debt than what they would have been able to wring from the Treasury and their bargaining power is now reduced.(New York Times, October 25, 2008 When will the banks start making loans? ) Despite all these measures the indicators still point to falling prices, failing firms and increasing job layoffs.
It is of course one of the structural weaknesses of monetary policy pointed out by Keynes and admitted to by D.H.Robertson that `the banking system may be hard put to make the money supply large enough, and keep it moving fast enough , to check the fall in prices ” in a crash or depression. (D.H.Robertson, Money, p.177) That is why in addition to these financial infusions there is a need for additional fiscal stimulus.
Nationalizing banks, even partially and temporarily still takes us back to the days of FDR. It is a long way from rational markets theory and the philosophy of laissez-faire. There is no going back in the near future or even medium term to the economics of deregulation and laissez-faire capitalism after this. No less a free markets advocate than Alan Greenspan has admitted that his deregulation ideology was flawed and that he was shocked and in a state of disbelief by the failure of banks and financial institutions to properly self regulate the derivatives market and protect shareholders’ interests. (House testimony) No one for many years to come will be able to credibly argue for deregulation of the financial markets and laissez-faire knows best after these cataclysmic and paradigm shifting events.
Instead of rational markets we were confronted with a global market crash and a financial system that was perilously close to complete paralysis and failure. One of my colleagues has suggested that the markets did behave rationally by panicking and seeking to sell off equities that it viewed as horribly overvalued because of their exposure to the derivatives fiasco.
But this is disingenuous because of the origins of the derivatives crisis itself in the absence of market regulation. Laissez-faire obsession accompanied by excessive greed played a major role in unleashing this crisis.
But whatever its origins it has developed very swiftly into a once or twice in a century financial panic along the lines of the 1873 banking panic that was also based on a housing bubble, the 1907 collapse that was rescued by the joint intervention of the Government and J.P.Morgan and the collapse of the markets in 1929 and 1930 which ushered in the Great Depression. Some analysts on the left, such as, for example, Dean Baker(see the Guardian, October 3, 2008) as well as some on the right had insisted that President Bush, Hank Paulson and Ben Bernanke the Chairman of the Federal Reserve, who have warned of the risk of this crisis being as grave, were exaggerating the problem in order to advance their own special interests or agenda .
Current events in the markets suggest otherwise. Prominent market analysts like George Soros, Robert Schiller and Warren Buffett have been suggesting the possibility of an event of this magnitude long before President Bush spoke of it. Hyman Minsky suggested that it was a possibility two decades ago. The freezing up of the inter-bank loan market and the withdrawal of funds from the stock markets was already underway before President Bush warned of dire consequences .
Anyone who has studied or carefully observed the behaviour of mass society in the post-modern age knows that panics, crashes and irrational manias are an integral part of contemporary culture. Kindleberger, Minsky and Galbraith have shown in their own work just how powerful these kinds of destructive forces were in the past. There is not much of a leap from tulip bulbs, the South Sea bubble John Law and Mississippi swamp land to grossly inflated land values and overpriced cottages and houses and arcane derivatives that exploit lack of transparency to mask fraudulent overleveraged pricing. The irrational aspect of human nature and tendency to panic is a constant.
This aspect of human nature has been magnified and accelerated in the contemporary world. As John Koning a Toronto economist and investment dealer who writes from an Austrian perspective has pointed out the panics of the past are incorporated into the collective memory and they hence make it more likely for mass psychology to follow a familiar pattern.(See also Niederhoffer,McKay and Kindleberger) In the post modern world of click and blackberry culture and fleeting attention spans that typifies our world it is not a surprise to witness a financial panic that accelerates at a fearsome pace. An updated and effective regulatory framework will need to keep this in mind.
It will take time and considerable effort on a broad range of fronts to re-establish some stability and the absence of panic.
The immediate priority of the new Obama Government in Washington next January will have to be a reassessment of the legislation to fix whatever gaps still exist in it; a restructuring of the American auto industry; a massive fiscal stimulus perhaps as much as $500 billion that targets neglected infrastructure and creating jobs for low and moderate income people; programs to aid the poor, the homeless and those who are facing unemployment; repair and reform of the health care system to bring it up to a modern standard for an advanced capitalist country; and aid along the line that Stiglitz proposes for those who are facing foreclosure. The last is partly mandated by the Bill that has just been passed but undoubtedly will need improvement.
Here one can use a housing stabilization fund (HSF)or relevant portions of the TARP that relieves burdened homeowners of part of the mortgage and renegotiates the terms so that the liability for the relieved portion is shared between the original mortgagee and the HSF. In return for this aid the homeowner assigns an appropriate portion of any future capital gain to the HSF. I first developed a scheme like this more than thirty years ago when I was a government housing economist in Manitoba and was tasked with developing a scheme to prevent the benefits of a government land assembly from being totally captured by the first buyer of the property as opposed to being passed on to future buyers in perpetuity.(see my blog haroldchorneypoliticaleconomist.piczo.com April 7, 2008)Soros and others have proposed variants of this scheme in recent articles.
Although the deficit is being increased by these measures it is important to keep things in historical perspective. A one trillion dollar increase in the deficit adds about seven percentage points to the deficit to GDP ratio. So if a $500 billion fiscal stimulus were added to, say, a $500 billion dollar capital injection and the rescue of some toxic assets over the next two years(I am assuming that some assets will be insured rather than bought by TARP. Some will also be bought by private market actors. Some will also turn profitable over time) on top of about $300 billion for Freddie Mac, Fannie Mae and Bear Stearns and AIG the resulting deficit to GDP ratio would be significant , above 10 % of the GDP. During the Second World War the deficit soared to as high as 30 % of the GDP in 1943. It was above 20 % in 1944 and 1945.
At the moment financing costs are very low because of the enormous demand for quality government debt. The proportion of the debt held by the Fed is low, about 6 % as a proportion of the GDP as compared to 10.7 % in 1946.With careful management by the Federal Reserve including its intervening to keep the financing costs minimal through the purchase and resale of these assets there is no reason for the increase in the debt to cause any sort of alarm.
In 2006 the net debt (that is gross debt minus debt held by Federal Government accounts) to GDP ratio for the US was quite manageable, under 38 % of the GDP. (See Table 7.1 in The budget for fiscal year 2008, pp126-127.)
Even after expanding it to accomplish these goals it will still be very manageable, close to 50 % of the GDP.
As calm gradually returns to American and global financial markets which will take some time, the harrowing events of this past year will enter the history books as another powerful example of the limits of laissez faire and the necessity of countervailing regulation and a progressive state that uses Keynes style technique in order to bring humanist reason to bear on the extraordinary destructive but also potentially extraordinary creative power of advanced capitalism in the age of globalization.
References and Further Reading
New York Times, September, October and November 2008 daily issues.
Wall Street Journal, September, October ,and November 2008 daily issues.
Financial Times, September, October, and November daily issues.
HR1424 Emergency Economic Stabilization Act 2008
Dean Baker, “A crisis made in the Oval Office: A financial panic provoked by President Bush was designed to stampede the Congress into passing the bailout for Wall Street , ”October 3, 2008 www.guardianco.uk/commentisfree/cifamerica/2008/oct/03US.bush.financialcrisis/
Ron Chernow, The House of Morgan: An American Banking dynasty and the Rise of modern finance
Harold Chorney, www.piczo.com. haroldchorneypoliticaleconomist
Harold Chorney, “Debts, Deficits and Full Employment ” in R.Boyer&D.Drache, States against Markets:The Limits of Globalization, N.Y. Routledge, 1996
Simon &Schuster, N.Y.1990
Robert Bruner&Sean Carr, The Panic of 1907, N.Y. John Wiley, 2007.
John Kenneth Galbraith, The Great Crash, N.Y. Houghton Mifflin, 1954,
John Maynard Keynes, The Treatise on Money, vol.2 London: Macmillan vol.6 of Collected Works, 1930.
Paul Klemperer, Auction Theory: A guide to the Literature Journal of Economic Surveys vol. 13(3) www.nuff.ox.ac.uk/users/Klemperer/survey.pdf
Charles Kindleberger, Manias, Panics and crashes, N.Y. Harper, 1978.
Axel Leijonhufvud, Keynes and the Crisis Policy Insights, May 2008, Vol.23.
Axel Leijonhufvud & Brian Snowdon Snowdon interviews Leijonhufvud, www-ceel.economica.unitd.it/staffleijonhufvud/interview.pdf 2002.
Charles Mackay, Extraordinary Popular delusions and the Madness of Crowds, N.Y. Harmony Books, 1841, 1980.
Hyman Minsky, Stabilizing an Unstable Economy, New Haven, Yale University press, 1986
Victor Niederhoffer, The Education of a Speculator, N.Y. John Wiley, 1997.
Historical Tables: Budget of the US government, fiscal Year 2008
Kevin Phillips Bad Money: reckless finance, Failed Politics and the Global Crisis of American Capitalism
D.H.Robertson, Money, Cambridge, Cambridge University Press, 1946.
George Soros, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means
Harold Chorney
Professor
Political Economy and Public Policy
Concordia University, Montréal
