The Wall Street Journal-20080119-Hot Topic- The Panic Stage
Return to: The_Wall_Street_Journal-20080119
Hot Topic: The Panic Stage
In his book "Manias, Panics and Crashes," the economic historian Charles Kindleberger describes the stages of financial boom and bust. Students of the good professor will recognize where we now are in the current credit crisis: the panic stage. It isn't a pretty sight, but a crash is far from inevitable if political and economic leaders keep their wits about them and focus on the proper remedies.
Amid the daily market turmoil, and to help prevent a crash, it helps to step back and remember how we got here. With the benefit of hindsight, everyone can see that the U.S. economy built up an enormous credit bubble that has now popped. Our own view -- which we warned about going back to 2003 -- is that this bubble was created principally by a Federal Reserve that kept real interest rates too low for too long.
In doing so the Fed created a subsidy for debt and a commodity price spike. The price spike contributed to "excess savings" in countries with a low propensity to consume and which channeled that money back to the U.S. That capital flow and debt subsidy, in turn, became fuel for smart people in mortgage companies, investment banks and elsewhere to exploit. In a sense they created a new financial system -- subprime loans, SIVs, CDOs, etc. -- that is enormously efficient and brought capital to new places. But thanks to low interest rates and human enthusiasm, this debt spree also got carried away. This was the mania phase.
Thus we were told that rising housing prices were no problem, even as they climbed by 20% or more a year in some markets. Demographics and immigration could explain the boom. Credit spreads narrowed to unheard-of levels, but neither lenders nor investors seemed to mind. The rating agencies added their AAA blessing, and financial CEOs basked in rising earnings from investments they little understood.
The political class now attributes this to greed and fraud, and there is some of that in any mania. But most was the product of creative Americans responding to the incentives for debt that the Fed created. The politicians also enjoyed the boom while it lasted, spending the tax revenues, feasting off Fannie Mae campaign dollars, and celebrating the spread of home ownership. No one wanted it to end, which is why there was so much caterwauling once the Fed did begin to remove the debt-subsidy punch.
This does not mean that this decade's growth has been illusionary, any more than the 2000 bursting of the dot-com bubble means growth in the 1990s was fake. Enormous wealth was created in both periods, new industries have developed, and in the current decade there has been a genuine global boom. The excesses have been based mainly in housing and finance, and that is what now threatens the larger economy.
Enter the panic stage. The desire for debt has turned into a stampede to quality, especially Treasury bills. The same folks who never predicted the economy would recover in 2003 are now cheerleading recession. Any bank writedown or deal to raise capital -- no matter that it is part of the healing process -- is taken as a sign that there is more bad news to come.
Meanwhile, the politicians plot to "stimulate" the economy by dropping dollars from the Capitol dome. We are also told the Fed funds rate must chase the 90-day T-bill rate down to the levels it reached when we had negative real interest rates -- never mind the anemic dollar and soaring commodity prices. The danger now is that this panic becomes a self-fulfilling prophesy and talks us into a crash.
There are two ways in which a crash could happen. The first is insolvency of one or more financial institutions that triggers a systemic failure. The second is a loss of global confidence in U.S. financial management and the dollar. Neither has to happen.
On the first, progress is already being made. Banks and mortgage companies are taking back their off-balance sheet assets, writing off losses, and seeking new capital. There seems to be no shortage of such capital available, and this is a healthy sign. Meanwhile, the Fed has been making creative use of its discount window, with new auctions and accepting different collateral to help ailing institutions that need to borrow. This outlet has already helped to reduce the credit spreads that ballooned late last year, and is calming lending markets.
We are only in the early stages of this repair operation, and no doubt some companies will fail. The task for regulators is to avoid surprises that cause more panic and above all to prevent systemic contagion. Warren Buffett's recent entry into the troubled bond insurance market is another sign of the marketplace helping to heal itself. In cases where there is real systemic risk, the government through the Federal Deposit Insurance Corporation may have to rescue some institutions. In those cases, the equity holders need to be zeroed out and the management replaced. The overriding goal is to keep the banking system functioning.
As for the other crash scenario, we wish the Fed hadn't squandered so much credibility this decade. Then it might be better placed to reduce interest rates as fast and as far as Wall Street and Donald Trump are demanding. But with prices rising and the dollar as weak as it's been since the 1970s, the Fed has less room to maneuver.
Expectations of further easing have already caused oil and other commodity prices to surge in a way that robs much of the stimulus from lower rates. Higher food and gas prices have hit consumers hard and are part of the reason for reduced consumer spending. The worst case would be a global run on the dollar that left the Fed no choice but to tighten money dramatically.
---
So what to do? Pass a tax cut that is immediate, marginal and permanent. In the "stimulus" grab bag that President Bush is contemplating, the only growth driver is bonus depreciation. Congress will be worse. As for the Fed, continue with the regulatory triage, but ease as little as it can get away with and slowly restore the monetary credibility that was so painfully earned in the 1980s.
This recipe may or may not prevent a recession, though we'd note that so far the underlying economic indicators suggest slower growth rather than a contraction. What these policies would do is prevent today's panic from becoming something much worse.
