The Panic of 2008 and Financial Socialization
by Michael S. Rozeff
by Michael S. Rozeff
The Panic of 2008 parallels the Panic of 1873 in important ways. It differs in others. The comparison is instructive.
Considering the resemblance of 2008 to 1873, we may experience a serious depression of 3—5 years. The most important difference is the response of government. President Grant vetoed a Congressional bill calling for a large issue of greenbacks (non-interest bearing government notes), whereas the Panic of 2008 involves the socialization of American finance. This is occurring now via the Emergency Economic Stabilization Act of 2008. Secretary Paulson has already made 9 major banks sign on the dotted line. The Federal Reserve is emerging from this episode in weakened condition as an appendage of the Treasury.
Let's look at the Panics of 1873 and 2008. Preceding the Panic of 1873 was a boom in railroad building. Preceding the Panic of 2008 was a boom in housing. The Federal government had subsidized construction of such major railroads as the Union Pacific, Central Pacific, and Northern Pacific through land grants and low-interest loans, starting in 1862 and ending in 1869. In the recent housing boom, banks were urged to use their ample reserves to finance home purchases by subpar borrowers.
In both these cases, the government established a framework, regulatory and monetary, for intensive expansion in an industry. Private industry then rose to the occasion and responded vigorously.
The buildout of the rail system through related lines caused a boom in iron, labor rates, and transport, among other industries. The price level rose steeply for many items. In the housing boom, home prices rose steeply. So did many prices throughout the economy.
There was not enough domestic capital to support the railroad boom. Bonds needed to be sold. They were sold here and abroad to banks with ample reserves. In the 2000s, securitized bonds were placed in the hands of many financial institutions. This included many foreign banks who were flush with cash due to loose money policies of many central banks.
The rail financiers included investment banker Jay Cooke who had for years built a reputation on marketing government bonds. In our time, brand name investment banks and bankers distributed the mortgage securities far and wide. Reputations are important in placing credits on a wide scale, but it helped that Cooke's bonds carried a promised rate of 8.5 percent. People ignore risks of default when returns are attractive and the seller has a sound reputation. In the recent case, bonds were sliced and diced into tranches to produce attractive promised returns. Rating agencies lent their reputations to these securities. New methods were invented to insure credits. Investors ignored the fact that promised returns are not always the same as realized returns. They ignored downside risks. This was made easy by a trend of rising house prices that had been going on for decades. But housing prices can fall, ratings can be revised downwards, and credit insurers can fail.
In a boom, all the main businesses involved in the boom are making handsome profits. Homebuilders, home suppliers, mortgage bankers, banks, and investment bankers, among others, all did well in the housing boom. Many investors along for the ride got above-average returns. They were anxious to supply even more capital.
The boom by definition is a period of above-average business activity enabled by financial credits. Production and finance are both stimulated. Both receive the abnormal stimulation of government regulatory and monetary policies. The boom of 1869—1873 involved a banking system that created money backed by government bonds. The Fed does the same today. In both cases, it also involved Congressional stimulus. In the 1860s, it was railroad subsidies. In this century, it was a variety of measures to stimulate house construction and to absorb the mortgage credits via government-sponsored institutions like Fannie Mae and Freddie Mac.
Government leads the boom, business follows. Government prepares the boom. Wall Street commits it. The government's tracks are hidden. Wall Street's are not. Few blame government for the inevitable bust. Many blame Wall Street. Government investigates Wall Street and makes sure of that.
Invariably, some firms go at it with a vengeance. By being first or most adept or best-situated at exploiting the opportunities, they grow the fastest, make the most money, and become the largest and best-known. The reputations of these firms for making good decisions and money grow. This attracts capital, and they grow even larger. Thus we get investment bankers like Jay Cooke, Bear Stearns, and Lehman. In Great Britain, we got Northern Rock. In Germany we got several German Landesbanken using short-term financing to buy American mortgages. Likewise, in 1870 German and Austrian governments supported banks in their lending activities, causing a building boom.
In growing, some firms win the most business because they take the biggest chances. This they do on both sides of their balance sheets: assets and liabilities. They load up on risky assets and extend too many risky loans. This raises their business or operational risk. The problem with this is that if those assets fail to produce the expected cash flows, the firm doesn't have enough cash to pay its bills or service its debts. These firms also borrow the most to expand. This raises their financial risk. Since they are making money, they tend to ignore the possibility of downside risks and losses.
An especially risky procedure is when firms borrow using short-term loans (such as three-month or even shorter loans) while buying risky long-term assets. The inducement to do this is that short-term interest rates are usually lower than long-term interest rates. The problem is that the borrower has to re-finance the loan frequently. If that financing is not available or its costs suddenly rise, the borrower faces bankruptcy.
The Northern Rock failed in Great Britain on September 13, 2007. The Treasury report is available on what happened. It is clear that this lender expanded very greatly while employing lots of borrowed capital including short-term borrowings. Countrywide was similar. These institutions had undertaken some measures to obtain back-up funding in case of tight money. They were not simply foolhardy. However, they did not conceive that all of their backups might fail to back them up. They did not conceive that the markets for their risky assets could become so illiquid that they were incapable of being sold to get funds. They did not conceive that when these assets became illiquid, short-term lenders would no longer provide funds to finance holding them. In short, they did not understand the risks they were taking. Their business and financing strategies were flawed.
The entire production and financing structure in a boom is predicated on (a) prices being realized that provide the high returns to service the debts, and (b) credits being available to finance the assets. When prices start falling and/or when credits start drying up (or tightening), the boom falters and fails. Prices fall when the cash flows of the assets become insufficient to service the required cash flows of the financing. This happens when investment in assets has run too far into questionable areas such as rail tracks that do not carry enough freight and sub-prime mortgage loans to borrowers that probably cannot afford them. These marginal investments do not live up to expectations. The tendency as the boom progresses is to under-estimate the real risks of cash flow shortfalls, or to apply too low a discount rate to the cash flows of long-lived assets. Optimism prevails because optimism is what has been paying off. Risk premiums become too low, which is another way of saying that marginal investments are accepted and thought to be profitable.
Credit tightens for several reasons. When short-term lenders notice that asset prices are falling, they no longer renew the credits. When lower quality asset investment outruns the pool of financing, higher rates are charged. When central banks and major banks begin to believe that they may be called upon to fill backup lines of credit, they slow down the growth rate of their credit.
This leads into recession and often into a panic. A panic is a period of sharp price declines of stocks and other long-term assets accompanied by great difficulty in obtaining credit. Failures of major financial firms occur. Business is often already in decline before the panic. After a panic, business goes into further decline, or it starts declining if it is not already in decline. Prices of raw materials, commodities, and commodity-type goods and services drop sharply.
Europe had a panic in May of 1873. This held up financing in the U.S. and affected bond underwriters like Jay Cooke. They relied on short-term financing. They had to use their own credit when European sources dried up. This strained their enterprises. Money rates began to rise. Things looked sound, despite the high prices for goods that had been incurred in building the roads and the high costs of capital. But there was too much borrowing short and investing long, a duration mismatch. If the long investments did not produce cash flow, there would be a big problem rolling over the short-term debts. When commercial paper went to 7—12 percent, the failures started. In September Jay Cooke failed. Then a slew of banking houses failed. Stocks dropped as banks called in loans and margin accounts were forced to liquidate. The banks were seeking money funds so that they could avoid failure. This induced runs on banks. The Clearing-House Association issued certificates. Hoarding of money took place as in other panics. The banks could not find and keep currency. Good short-term paper got up to 30%. Trade and industry became severely depressed for lack of currency. The panic lasted from Sept. 18 to Oct. 13, at which point with call money at 7% and commercial paper at 15—18%, the banks were able to operate. Those rates brought in funds from investors.
The depression in business that followed lasted from 1873 to 1877 or 1878. This was the aftermath of the prior boom and the panic that ended the boom. This may be our fate in 2008.
During the crisis, President Grant and the Treasury were asked to issue greenbacks held in reserve. They refused to support the money market. They did buy bonds with greenbacks ($18,000,000 worth). The Congress then passed a measure to issue half a billion or so of greenbacks (which was a very large amount). Grant vetoed it.
This time around we have Paulson and Bernanke instead of Grant. There is no veto. Far from it. There is a great deal of money-pumping. This will cause stagflation. The Fed is the cause of stagflation by slowing, then pumping, then slowing, then pumping in succession. The slowings produce the stagnation. The pumpings produce the inflation. The alternation produces uncertainty and confusion. Prices of consumer goods move with lags, and the money effects have lags. This makes direct connections to Fed actions hard to see. The uncertainty means that not everyone views the processes in the same way. Some people think inflation and some think deflation.
Other things are different in 2008. People are hoarding again, but in T-bills, not cash. Rates have risen on commercial paper and LIBOR, but they are not high in absolute terms. They are not 7% or 12—15%. Why not?
Instead of a modest amount of clearing house certificates being issued, we have a huge amount of Fed activity. Why has this not relieved the Panic of 2008? Why has it made it worse?
The relief of the Panic of 2008 has not happened in 1 month as in 1873. Instead it has lengthened out from early 2007 to now. Why?
Why does the modern panic follow such a different course than the panic of old?
The answer is that we have one or two more rungs on the institutional ladder. The central banks are a new rung. They prolong the agony. They have been prolonging the agony overseas and here for months now by lending to failed institutions.
These measures do not and cannot restore credit because they are based on a misconception of credit. The Fed acts as if credit can be injected into a market. It refers to it as liquidity. It acts as if it is passing liquid refreshment to a parched athlete. It and many others think of the Fed as the lender of last resort.
What this means can only be grasped by comparison to a free market system. There can be and is no such animal as a lender of last resort in a free market system.
There are many lenders and potential lenders in a free market. Evaluating creditworthiness is at the heart of lending. This obviously cannot be done efficiently by any one lender, given the large numbers of different kinds of borrowers with different assets and credibility spread over wide regions. In a free market, borrowers obtain the bank notes of individual banks issued against their productive potential and assets. These notes can become currency and money. Borrowers are able to pass them to others only if the public has a readiness to accept them based on actual experience and their worth. The public calls the tune by establishing the value of these bank notes. If the public believes in the assets behind those notes, which may include gold, collateral, and bank loans that finance various business ventures, then the notes sell at par. If they fall below par, competing banks have an incentive to present them to the issuing bank and demand specie (gold). It is an arbitrage profit opportunity to buy a note for $0.95 and receive $1 worth of gold for it. The public markets thus check any bank that overissues its notes or that makes bad loans. The lender of first and last resort in a free market is the individual issuing bank, which, to add one complication, may have a relationship with correspondent banks.
Compare central banking. The Fed makes loans in conjunction with an associated banking system that evaluates borrowers. The latter operations mimic the free market since banks compete in making loans. However, the root of this arrangement is not a free market. All the banks use a single note series, which is the Fed's notes (the currency we use daily). Furthermore, the public has no mechanism to redeem these notes and obtain specie when they fall in value. There is thus no check on bank lending via note redemption.
In its open market operations that supply reserves, the Fed does not evaluate the loans of the individual banks. It supplies reserves to all of them. The Fed is not a lender in the sense of evaluating loans. No matter how many bad loans the member banks make, the Fed can supply them with more notes to provide to borrowers. This undermines the banks' incentive to evaluate the creditworthiness of those who are borrowing. Why should they when they can turn to the Fed for more reserves? In terms of economic function, the Fed is not a lender of last resort. The Fed is set up as "printer of last resort."
It appears that the Fed's presence in the market is holding down short-term money rates. Without the Fed, we might see call money at 7 percent and commercial paper rates at 12—15 percent as in 1873. Rates like these would draw money out of the woodwork and hasten the end of the panic.
With the power to restore the reserves of failed banks, the Fed supplies a new financial institution that confronts the panic. It is a formidable sea wall against hurricane driven surf. But at some point during some panic, there will be a run on the Fed and it will go bankrupt. Not being able to redeem from the Fed, people will attempt to redeem currency for goods en masse, driving their prices up and the value of the currency down. That will be the panic that ends the current system.
The Panic of 2008 is drawing us closer to the possibility of Fed bankruptcy than ever before. Each new action of the Fed undermines its balance sheet further. The strings are tightening around the Fed's neck. The Fed is rapidly becoming nothing more than an arm of the Treasury.
Treasury is the topmost rung on the ladder. The Treasury is attempting to control the banks directly and prevent business from falling into deep recession. The Fed has been demoted. It's a bookkeeper and a printing press. Someone in the basement of Fifteenth Street and Pennsylvania Avenue can operate a printing press just as easily as someone on Constitution Avenue and Twenty-First Street.
The Treasury has singled out its favorite 9 banks already. The debt market for Treasuries will be maintained by these banks and the 19 primary dealers that the Fed is already heavily supporting. The Fed is a useful façade for Treasury to have around. But the Treasury now owns these banks. The direction of the future is clear — all power to the Treasury.
There will be no economic collapse yet. The only collapse is that the Fed and banking are being collapsed into the Treasury or government. We are only at the beginning of that process. This process ends with the collapse of capital markets as we know them, since the investment bankers are gone and since the SEC regulates the capital markets. The bailout act includes a Financial Stability Oversight Board. Paulson previously was on record for wanting a financial commissar or czar. Great Britain is going the same way. The Treasury report there calls for a "Deputy Governor and Head of Financial Stability," their name for a czar.
The notion that the government can create financial stability is unbelievable to anyone who has the least experience with financial markets. It can be dismissed out of hand. One of the main tasks of a stock market is price discovery. That involves impounding information and re-valuing securities constantly. Financial stability is neither desirable nor possible for government to create except by destroying free capital markets. The government's financial leaders are either out of touch with reality, or else they are intent on cementing in a state capitalism or state socialism with controlled capital markets. Either way, the result is the same — a noticeable shift away from free capital and money markets.
Finance is being socialized before our eyes. We are embarking on a New Financial Deal that revamps and updates the New Deal. How far we go and how soon it transpires is guesswork. This socialization moves us toward lower social welfare. Economic stagnation becomes more likely. Collapse is not quite upon us, but it's closer. See Nazi Germany between 1932 and 1940 for parallels. A command economy with favored sectors is the result. Various controls crop up to paper over problems. The real standard of living declines. Shortages crop up. Many good ideas fall by the wayside and do not get financed. The government absorbs the savings, such as they are, or extracts them by one means or another. Business joins more strongly to government. Government lets the shells of business and banking remain standing. Expect a new fascist rhetoric to emerge to paper over the existence of a dictatorship, American style. Expect more such terms as Homeland and Financial Stability Oversight Board, which is a devious and roundabout way of saying Financial Dictatorship.
October 20, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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