Panic: First Wall Street, Then Main Street

We have not yet seen panic on Main Street. The malls’ parking lots are full. Most yuppie restaurant chains are still in business. Their local restaurants may not be as full as they were a year ago, but they are open for business. There are still shoppers at Wal-Mart.

Unemployment is now increasing by leaps and bounds. It rose from 7.1% in December 2008 to 7.2% in January — not too bad. Then came February: 8.1%. Then March: 8.5%. In one year, according to the April 3 press release of the Bureau of Labor Statistics, 5.3 million people became unemployed. This was an increase of 3.4 percentage points. Most of this increase has been in the past four months.

Americans are uneasy. Those with pensions have seen significant declines in their holdings. The net worth of the median household declined by 23% in 2008 — an unprecedented fall in the post-War era.

We have not yet seen panic. I think we will before the end of 2009. If not in 2009, then in 2010.

By panic, I mean a sharp shift in people’s spending habits. I mean half-empty parking lots at the mall. I mean a decline of at least 50% from today’s income at yuppie restaurants. People will finally start saving again, if they can. Credit card defaults will double. Already, the figure is over 4%.

On April 1, Moody’s downgraded U.S. corporate debt by $1.76 trillion. Moody’s said this was the largest single downgrade ever. This signals the worst level of defaults since World War II. Moody’s chief economist, John Lenski, put it this way: “Business sales and profits fell off the table in general in the final quarter of last year and have continued to deteriorate in the first quarter in 2009.”

There are those in the financial forecasting industry who say that the recession will end late this year. None of these people forecast the recession that began in December 2007, nor did they predict the collapse of stocks. They say there is light at the end of the tunnel.


On April 6, Federal Reserve Board member Kevin Warsh gave one of the most forthright speeches I have read from any FED Board member, ever. He was almost breathtaking in what he admitted in front of a group of high-level international investors. He titled his speech, “The Panic of 2008.”

This panic arrived 101 years after the famous Panic of 1907, also known as the bankers’ panic. It was in the aftermath of that panic that the Rockefeller and Morgan banking interests decided to call a truce in order to lobby for the creation of a central bank.

He began with a litany of problems — problems of recession.

Deterioration in employment conditions. Pullback in consumer spending. Decline of industrial production. Retreat in capacity utilization. Falling capital expenditures. These measures are objective, all-too-familiar indicators of recessions.

His speech contrasted recessions with panics. Recessions are common. Panics are not.

Fear. Breakdown in confidence. Market capitulation. Financial turmoil. These words are different, not just in degree but also in kind. They are more normative, but no less consequential to the real economy. They are indicative of panic conditions. In panics, once firmly held truths are no longer relied upon. Articles of faith are upended. And the very foundations of economies and markets are called into question.

He believes that the panic of 2008 called the entire banking system into question, and perhaps more important, called into question the reliability of contracts. He has in mind contracts between financial institutions and the U.S. government. Above all, the near bankruptcy of Fannie Mae and Freddie Mac and the bailout of October called the financial structure into question.

He said that the beliefs of economists have been challenged.

Some economists, market participants, and historians — not so long ago — were prepared to relegate these highly charged descriptions of despair to the dustbin of history. Government policies improved, understanding of economics deepened, and markets found a more sustainable equilibrium, or so it was thought.

This optimism was premature, he thinks. We have now seen events that have called this facile optimism into question.

The encouraging news, I should note, is that panics end. And this panic is showing meaningful signs of abating.


The problem with this optimism is that he confines his discussion of panic to Wall Street. It was panic among the financial insiders. He does not even mention the panic of the common American. He therefore ignores the next phase if the panic, when it moves from Wall Street to Main Street.

The enormous losses sustained by the financial markets have made their way into the budgets of Americans, but not on the order of magnitude experienced by Wall Street. The common American was not leveraged 30 to 1 in 2007. He was not subject to margin calls, just so long as he maintained his monthly payments. This was not true of Bear Stearns and its clones in the hedge fund world. The average man has no pension. He has only his job, and he has not lost it yet.

Warsh describes events of 1907. They parallel events in 2008. There was one overwhelming difference: bank runs. In 1907, bank depositors withdrew currency and did not re-deposit it. That reversed the fractional reserve process. Bank capital imploded. This did not happen in 2008, nor can it. Depositors transfer deposits to different banks. The total deposit base does not decline for the system.

The bank runs of 2008 were executed by banks. They have stashed money — excess reserves — with the FED. The bankers have pulled the plug on the fractional reserve process. They have not lent out all the money that the FED’s increase in its monetary base would allow. Warsh does not mention the problem of excess reserves.

The current financial and economic turmoil is marked by indicia of both recession and panic conditions.

I don’t use words like “indicia.” I prefer “indicators.” But however one denotes them, the indicators are bad. He compared the recession with the recession of 1981—82. This is common these days. But it neglected two fundamental differences:

1. Unemployment went above 11% in 1982.

2. The savings rate went to 10%.

Neither of these events has taken place so far. So, the recession has a way to go before it reaches the level of despair and panic that we had in 1982. Be patient. It will get there.

Economic output, as measured by gross domestic product, contracted at a rate of about 6-1/4 percent in the fourth quarter of 2008 and is on track to contract sharply again in the first quarter, which would put the current contraction among the most severe post-World War II recessions.

He thinks this decline is abating. This assumes that the panic we saw in 2008 on Wall Street does not play itself out on Main Street to the same degree. If it does, the economy will go off a cliff.

What about economic recovery? Warsh is not optimistic.

The panic conditions that have marked this period may also have long-run implications. I suspect that the process of an efficient reallocation of capital and labor will prove slower and more difficult than is typical after recessions. Policymakers should be wary of policies that make the economy still less capable of the growth, productivity, and employment trends that have marked the postwar period.

Yet this is exactly what policymakers have done so far. They have lurched from one expensive bailout to another. The public is beginning to perceive that the bailouts are for the banks, not the voters. This has been the case so far. Warsh does not mention this, but his speech indicates that he understands it.

Greater clarity as to policymakers’ objectives for financial intermediation would likely prove very constructive to financial markets. More consequentially, in my view, it would improve the prospects for economic performance.

Clarity? How can they be clear? That would be political suicide. Their policies have had a sole objective: to preserve the largest banks and financial institutions on Wall Street. So far, their policies have just barely kept the doors open.

Meanwhile, Main Street is suffering losses — not so bad as Wall Street’s losses, but bad.

In the household sector, Federal Reserve data indicate that household net worth fell $11 trillion in 2008, or about 18 percent, the largest annual decline recorded. . . . For the median household, net worth is estimated to have decreased at a greater rate — 23 percent in 2008. Household balance sheets may have contracted about another 7 percent in the first quarter, and I am watching keenly for that trend to change in subsequent quarters as part of the recovery.


He understands that the general public is losing faith in the system. Those of us who are Austrian School economists think there is far more faith remaining than the system deserves. But Warsh senses that the masses are getting restless.

As a result, households are questioning the route to financial security. Homeownership is no longer perceived to ensure low-risk capital appreciation. And assurances by investment managers to invest in “stocks for the long haul” are being subjected to intense scrutiny. Investors of all stripes — sovereign wealth funds, large long-only institutional investors, private equity sponsors, hedge funds, and retail investors — are searching for new rules of asset allocation and appropriate risk premiums in an uncertain and unusual economic environment.

In short, investors’ confidence in the system and its present rules has suffered a major setback.

Previously, I argued that we were witnessing a fundamental reassessment of the value of every asset everywhere in the world. This diagnosis seems truer, and still more troubling, today.

He thinks that participants at the highest levels have lost confidence.

Market participants wonder whether the forms of financial intermediation and functions of financial institutions — long connecting savers with investors — will be implemented in a manner that will enhance, or reduce, economic well-being. Some are questioning the efficacy of the remaining vestiges of the existing financial architecture and remain uncertain of the timing, efficacy, and policy preferences for the financial architecture that will ultimately emerge. Surely, they applaud the goal of policymakers to reform the financial system to make it more durable through the cycle and less susceptible to shocks. But some query whether policy actions are, on balance, lessening or stoking panic conditions.

I have already offered my assessment. Between early September and late October, the United States economy moved to fascism. The government-business partnership ratcheted up so far that the older Keynesian model was abandoned.


At stake is the rule of law. He sees this.

Headlines have been dominated in recent weeks by the legal rules that govern contracts. To be sure, markets function best when economic actors comport themselves in a manner consistent with the rule of law. Fidelity to the rule of law is not just some aphorism for a judicial system to protect property right disputes among private parties. Nor should it be just some preachy truism of economic development for emerging economies. Rather, it is the linchpin of modern market economies like ours. And it suffers its greatest blow when the governing authorities are unwilling to uphold their end of the bargain.

As a good bureaucrat on the Federal government’s payroll — a FED Board member — he affirms his confidence:

Nonetheless, despite some highly publicized suggestions to the contrary, I remain highly confident that the government will work tirelessly to uphold its obligations.

Then he added: “Hewing to the rule of law, however, may be the easier part.” Why? Because more is involved here than government rules. The fabric of trust has been shred. What is this fabric? He called them articles of faith.

The panic bred by the loss of confidence in the underlying financial architecture is difficult to remedy beyond the purview of statutes and regulations. A weighty accumulation of unwritten, but no less critical, practices and understandings governs behavior and establishes expectations in market economies. Over time, these informal understandings attract deep and loyal followings by economic actors. They become articles of faith.

I could not have put it any better. He went to the heart of the matter in the change that took place between September and October of 2008. The old faith has been undermined at the highest levels.

Panics can thus be understood as periods in which key articles of faith are cast in doubt. How does this happen? After long periods of economic prosperity — in the most recent case, the so-called Great Moderation — articles of faith accumulate.

The boom fosters faith in the system. He recognizes that what took place in 2008 was not some typical recession. Something far more fundamental has changed.

Some of these articles of faith are rooted in government policies; others develop as a matter of private practice. Regardless of their cause and contour, when faith is undermined, the resulting fear and ambiguity can accelerate the deterioration in economic performance.

What happened last year? The senior financial institutions performed so poorly that faith has been undermined.

Some key articles of faith have been undermined with respect to some financial institutions. And that is as it should be. Risk-management failures at some large, systemically significant financial institutions are now legendary. In some cases, investors and counterparties came to rely to their detriment on these entities and their financial wherewithal.

All true. The question is this: “How do these institutions get back what they squandered?” Here, he gets vague.

Market participants appear equally uncertain about the nature, objective, and duration of the relationship between the government and financial institutions.

He sees the bailout of Fannie and Freddie as the archetypes of confusion.

These efforts, while necessary and well intended, have not completely resolved the uncertainty around the GSEs to market participants. Indeed, even after extraordinary actions most recently by the Federal Reserve to improve liquidity and market functioning in the agency debt markets, confidence in the GSEs is less than markets were long accustomed to before this period began.


His conclusion points to a restructuring of the present financial system.

To accelerate the formation of a new financial architecture, the official sector should outline and defend a positive vision for financial firms and welcome private capital’s return. The nature and terms of the relationship between financial firms and the official sector should not be left in limbo.

He has sounded a warning: the decision-makers at the top are preparing to re-structure the financial system. I have said that the deal was done last fall. What is not yet clear to anyone, at any level, is how this re-structuring will work. We are in uncharted waters.

Financial stability demands policy stability. The official sector’s policy preferences must be communicated clearly, credibly, and consistently and backed by concrete action.

The Federal Reserve was a deliberate mystery from 1913 until today. The heart of the monetary system is concealment.

Finally, and perhaps most important, policymakers across the government must be ever mindful of the long-term consequences of their actions.

Here is my conclusion, as John Wayne said in The Searchers: “That’ll be the day.”

April 8, 2009

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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