Have We Been Stampeded into the Panic of 2008?

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Reserve Study Paper #666

On October
23, 2008 the research department of the Federal Reserve Bank of
Minneapolis issued an important paper. Its title is "Facts
and Myths about the Financial Crisis of 2008

The authors
of this paper do not dispute that the United States is going through
a financial crisis as witnessed by major financial institutions
having failed and the fact that various stock markets have fallen
dramatically. They strongly disagree, however, with the most widely
voiced claims about the nature of the crisis and the extent to which
the problems of the financial sector are spilling over to the rest
of the economy.

Four primary
claims have been made about the current crisis by financial institutions
themselves, public policymakers and the financial press, as follows:

  1. Bank lending
    to nonfinancial corporations and to individuals have declined
  2. Interbank
    lending is essentially nonexistent.
  3. Commercial
    paper issuance by nonfinancial corporations has declined sharply
    and rates have risen to unprecedented levels.
  4. Banks play
    a large role in channeling funds from savers to borrowers.

Using data
from the Federal Reserve Board itself through October 8, 2008 the
authors of this myth shattering paper vigorously dispute all four
of these claims. They show that aggregate bank credit has not declined
during the financial crisis and, in fact, that total bank credit
available actually increased in September of 2008.

Along the
same lines, the paper shows that loans and leases made by U.S. commercial
banks have not declined during the financial crisis nor have commercial
and industrial loans to nonfinancial businesses. Finally, data for
consumer loans highlighted in the paper show no evidence that the
financial crisis has affected consumer lending. All of the figures
cited prove that the first claim about the impact of the financial
crisis — bank lending of all kinds has declined sharply — is false.

Data found
in the paper regarding interbank loans by all U.S. commercial banks
demonstrate that "at least in the aggregate" interbank
lending is healthy and has not been adversely affected by the financial
crisis. Thus, the second claim made about its impact is false on
its face.

With respect
to the commercial paper market, the authors point to data that shows
that such issues by financial institutions have declined, mostly
because huge increases in customer deposits have lessened the needs
of banks to raise money in this way. On the other hand, commercial
paper issued by nonfinancial institutions has been essentially unchanged
during the financial crisis. Also, the authors maintain that interest
rates on commercial paper have "barely budged." The third
claim about the financial crisis — that the commercial paper market
has dried up and the interest rates on such issues have risen dramatically
— is a myth, to put a kind face on the nature of these claims.

Finally, the
paper explores the nature of bank lending to nonfinancial corporate
businesses and concludes that such lending does not constitute the
bulk of borrowing of these businesses. In the second quarter of
2008 direct bank lending to businesses totaled $1 trillion. Funds
obtained by nonfinancial corporate businesses through the issuance
of public corporate bonds, however, is currently four times as great
(at $4.5 trillion) as the total from direct bank lending to these
companies. Obviously, banks do not play the most major role in channeling
capital to businesses and the fourth claim about the nature of the
current financial crisis is proven to be false by this paper.

The authors
also discuss the abnormally high spread between Treasury bill interest
rates and those of short-term corporate debt issues. Since — as
we have seen — the latter interest rates have remained stable, the
spread is due to the historically low rates currently being paid
on treasury bills. If one compares, on the other hand, interest
rates paid on investment-grade corporate bonds to those paid on
Treasury bonds of similar maturities, the spreads between them has
remained at historic norms throughout the financial crisis. Once
the current panic over short-term interest rate spreads and so forth
subsides, Treasury bill interest rates can be expected to rise to
more normal levels.

So, if the
major claims about the impact of our country's financial crisis
are myths and/or lies, why all the panic? Do the financial institutions
most affected by the crisis (i.e., investment banking firms and
those commercial banks truly in trouble), public policymakers and
the financial press not know the facts or have they deliberately
kept them from the American people? Have we been stampeded into
the Panic of 2008 and, if so, why? Will some benefit much, much
more than others of us from this stampeding?

27, 2008

W. Tofte [send him mail] is
the manager of the BWIA Private Investment Fund and the author of
Principled and Grow Rich: Your Guide to Investing Successfully in
Both Bull and Bear Markets
. He lives in Des Moines, Iowa.

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