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terça-feira, outubro 14, 2008

Déja vu: six steps that make a great panic

October 13, 2008

Déjà vu: six steps that make up a great panic

For 2008, read 1907. This time, however, China and India have emerged well, unlike America, Britain and Europe

It has not been too difficult to foresee the course of the 2008 credit crisis, since it has followed the classic pattern of financial panics. There has been nothing new so far; it is just that the world forgot the lessons of previous panics: an expensive oversight.

One of the classic panics occurred in 1907, when the failure of the Knickerbocker Trust precipitated a credit crash on Wall Street, which was eventually brought under control by the great US banker, J.P. Morgan.

The following year, Marlon T. Herrick, an Ohio economist, published an article, The Panic Of 1907 and Some Of Its lessons. in which he laid out the six stages in which panics occur. “(1) Failure of an important bank or institution: the Knickerbocker Trust in 1907; (2) Heavy withdrawals of funds by depositors; (3) Demoralised stock markets affecting banks and depositors alike; (4) Hoarding of money in large amounts, not only by individuals, but by banks; (5) Gradual improvement in financial affairs;

(6) Acute trade reaction, discharge of many thousands of employees, and realisation that the country must pass through a more or less severe industrial reconstruction.”

That was 1907; it might just as well have been 2008. For the British, Northern Rock was the important bank that helped to precipitate the panic; in New York it was Bear Stearns, followed by the disaster of Lehman Brothers.

Since then the financial world has moved from step one to step four of the 1907 pattern; hoarding of money, which Maynard Keynes termed “liquidity preference”, is still inhibiting the normal flow of interbank lending. We are stuck, for the present, in phase four.

However, the world will move on, as it always does. There will eventually occur a gradual improvement in financial credit, with some resumption of interbank lending stimulated by government interventions. Unfortunately, there will also be an “acute trade reaction” and a serious rise in unemployment - phases five and six of the 1907 formula are already in the pipeline.

The 1907 panic was the sixth- largest contraction in the financial history of the United States. As one commentator, Benedikt Koehler, has observed: “Once the storm subsided, the aftermath showed the world had changed irreversibly and did not return to business as usual. The crisis of 1907 set out in sharp relief that new forces in financial markets were in the ascendance.” One could take a similar view of all other big financial crises. That is again true in 2008.

The 1907 panic led to the creation of America's central bank, the Federal Reserve Board, under the Act of 1913. Subsequently, it was the 1929 panic that led to more stringent US banking regulations and, more broadly, to President Roosevelt's New Deal. The Great Depression that followed the 1929 Crash undermined confidence in democracy throughout the world and brought Hitler to power in Germany.

More recently, the inflation of the 1970s, which destroyed the secondary banks in London, brought Margaret Thatcher, and deregulation, to power in 1979, and Ronald Reagan in 1980. Financial panics occur when there has been a long-term build-up of new forces. When the dam breaks, that changes the whole landscape.

Before the 2008 crash, the United States was already widely seen as losing relative power, in politics, economics, and even defence. Entangled in Iraq and Afghanistan, it already had a large trade deficit and was borrowing from Asia on a colossal scale.

The rising power was not seen as Europe or Russia, but as China, the largest and most successful of the emerging Asian economies. Russia does indeed have very large reserves of oil and gas, and benefited when the oil price was rising, but it was China that had become a successful modern manufacturer and exporter.

If people looked beyond China for a rising economy, they saw India, also with a population over a billion, and with a growth rate two or three times that of the West. China has about two trillion dollars of currency reserves, a crucial asset at the present time. Neither Chinese nor Indian banks have substantial investments in the toxic sub-prime mortgages, because they had much better opportunities for profitable investment at home.

If China and India have been particularly impressive in the crisis, the other emerging Asian markets have performed reasonably well. They experienced the Asian crisis of a decade ago and learnt some painful lessons about the importance of liquidity. You do not need to tell Asian bankers that cash is king.

In the early stage of the present panic, Europe was complacent, taking the view that this was an American crisis, caused by holdings of American sub-prime mortgage securities in American banks. However, if the United States has been a big loser in the crisis, so has Europe. European banks turned out to have too much toxic debt and toxic derivatives. This was bad banking, badly regulated, whether it occurred in the US, the UK or the eurozone.

If anything, the European authorities lagged behind the American and the British. There has been no big consolidated European response, either from the European Central Bank or the European Union itself.

Britain has benefited from its freedom of action outside the euro. We could take our own decisions, some of which, admittedly, proved mistaken. To the irritation of Germany, the Irish Government gave an independent guarantee to the Irish banks; how that could be reconciled with membership of the euro is an outstanding question.

The IMF and the World Bank, the Federal Reserve, the European Central Bank, the European Union, the British regulatory authorities will all have to review their position. So will the world's largest banks. The group of eight will have to be extended to China and India. The world has changed; the world's banking system must change with it.

The West hasn't got the stomach for work anymore, only inflate & speculate on financial instruments, & now payback time.

ian cheese, london, uk

Let us see how well Asia handles a dramatic downturn in orders for manufactured goods. Factories in China are closing at record levels, causing massive payroll shifts from the private sector to the central government. A dramatic increase in crime is sure to follow. Always does.

Juan, San Diego, USA

William makes a good commentary on the 'crisis', however lessons must be learned from the 'good days' leading up to it which CAUSE the problem.

Dominic Graham de Montrose, London,

How very clubby of David UK, wanting to join the Europeans.
The world is now one very big club economically, however, as witness the current international panic. I think it behooves every nation to work collectively to maintain
reasonable economic stabilty. If this means more attentive oversight....

schmendric, Murphy, USA

I wonder why anyone would suggest entering the Euro. They have been unable to come up with a common policy and have ended up adopting ours.

Ironic when you hear people ranting on about Britain having no influence outside the Euro. You could argue that we're running the thing without belonging.

jon livesey, Sunnyvale, CA/USA

There are steps before your first point (1) failure of an important bank.... Include, banks and companies allowed to get, too big to fail and too big to manage. Also promotion of the wrong people, who don't treat other people's money like their own. When a collapse is allowed the crooks get fired.

Hugo van Randwyck, London, UK

It's a learning curve that every generation needs to go through. The goal should be to speed up the process so that pain bites sooner and is over with quicker.
Sadly though that might impair the learning process.

An interesting ride for everyone

Steve, Derby, uk

We must thank our lucky stars we have stayed out of the Eurozone. Membership would have involved a loss of independence on the exchange rate and higher and longer unemployment. America may be a busted flush but so is much of Europe. I, for one, do not want to be ruled by Brussels or Frankfurt.

William, Guildford, UK

Personnally, I would not write-off Russia in one sentence. It has all the raw materials it (& to an extent China and India) needs. It will soon own the meters on the EU gas supply. Put that into per capita terms on a population of 145m and you have wealth.

We have a "financial services" base...

Mike L, Chippenham,

A very good analysis AFTER the event.

The next crisis?

'Green financial instruments'?

Govt off-balance sheet liabilities?

Where can I lay bets on this eh?

Rhys Jaggar, Leeds, UK

This weekend proves that we can get along and lead a life without the doom-sayers having a platform to shout from. Will the panic start again Monday?

Phil, Atlanta, US

To David of Exeter,
Au contraire, recent events have only shown
disunity and an everyman for himself mentality in the Eurozone. Defections from the Eurozone, fi not break up, is more likely that any significant enlargement of the Eurozone.

Denver Watt, Osaka,

Ireland, a member of the eurozone, did its own thing. The UK, a non-member, is leading a coordinated response with France and Germany. Euro-membership has not been a relevant factor here. It would however have prevented currency devaluation in the UK with its inflationary effects.

Andrew, London,

There is an easily observable eighteen to twenty year economic cycle (once you subtract the war years) - each time Americas decline has been predicted, followed by a recovery usually lead by the United States.

Arnold Ward, Weybridge, Surrey, UK

We should thank Ireland for precipitating action within Europe. If they had instead defaulted without taking a lead, we would all be in a much more difficult situation. They forced European government to face the need to take responsibility. But rescuing the banks is only the first step to stability

Chris Coles, Medstead, Alton, United Kingdom

I would have thought this weekend proves quite conclusively that we must enter the Euro zone. America is a busted flush its time to join our European partners.

david, exeter, uk

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