Part 2: Providing Cash.
Starting in 1930, several convergent phenomena pushed what might have been
merely a severe post-crash recession into depression and ultimately
into Great Depression. Last week, I considered the first of these namely the rapid collapse of the consumer economy. In the 1930s, the speed with which the consumer economy could react to adverse events was largely an unknown and its effects were not well-anticipated. Today, of course, we have the benefit of our recent history to at least help us understand where we are headed, although our historical intelligence seems not to have assisted us in staving off crisis by squeezing leverage and tightening debt availability for the last decade. Nonetheless, there are signs that the lessons from the past have a least been partially absorbed at the level of public policy.
Fortunately, perhaps, the order of events today is somewhat the reverse of those in the 1930s. Then, the global financial system failed as a result of the crisis in consumer spending and the growing inability of households to manage their debt. Widespread consumer default pushed many banks out of business in the US. But even in countries that had stable banking systems (Canada was one, as it is today), the consumer-spawned financial crisis produced a flight to liquid assets and a freeze on commercial and consumer lending. The speed with which credit went bad sent many banks to seek the safety of liquid assets in order to shore up their balance sheet and protect themselves against a run. They curtailed their lending to all but the safest of risks. Money dried up.
That is a simplified overview, of course. There are a great number of economic theories about what caused the Great Depression. And there are a great number of theories about what perpetuated it and made it so much worse than earlier recessions. But in light of the 2007 credit crisis that presaged the current economic imbroglio, I note with considerable interest a 1933 paper published in the Harvard Business Review by Ditlew Frederiksen. He writes:
The words "frozen assets" have now been extended to towns and cities as well as to the country. This phrase, "frozen assets," has come into general parlance perhaps without exact definition. If we stop to analyze exactly what it is that makes certain assets "frozen," we find that, like all matters of credit, it can largely be reduced to a state of mind. People are not agreed as to the value of these assets, which are not stabilized, have no ready market, and have no large class of investors standing ready always to invest in them. They are not sufficiently standardized, classified or earmarked and approved and tested, so that a casual investor can readily distinguish among them.
A frozen asset is one which the investor or banker, not knowing whether it is sound or not, is afraid to touch. It may be good or it may be bad; it may be solvent or it may be financially impaired; if impaired, nobody clearly knows to what extent. … It is unsalable.
Like, apparently, the short-sighted bankers who peddled them, I know little about what is actually in a Collaterised Debt Obligation nor much about the underlying assets being "secured" by a Credit Derivative Swap. For the current market, these things are largely known unknowns, to quote the Zen-like mantra of Donald Rumsfeld, things we know we do not know. And from the point of view of risk management, if I know I don’t know, I don’t want. It becomes a frozen asset. It is unsalable.
The frozen assets Dr. Frederiksen was referring to in his 1933 paper were mostly US mortgage liabilities. The frozen assets that we are looking at today are far worse: not only the mortgages themselves, but the mountain of accrued positions – financed by heavy leveraging – that was built atop this unstable foundation. But what put so many asset classes into deep freeze in the 1930s was a financial system that quickly changed the terms of what it considered safe. Between 1930 and 1932, there was a wholesale shift to extend credit only to the most liquifiable of assets. In other words, the shock produced by the collapse of the consumer economy precipitated an extraordinary constriction in the financial system. Banks stopped lending. Moreover, as the Canadian example serves to show, this was not simply the result of bank failures. Even banks with compartively healthy balance sheets reacted in the same way. It was, as Professor Frederiksen notes, a state of mind.
Now I found Dr. Frederiksen’s interesting paper because Ben Bernanke, the current US Fed Chairman, actually quotes it in his 1983 article that I mentioned in part 1 (although he does not cite the section I have posted above). So Bernanke has presumably been having quite a sense of déjà-vu (or is it déjà-lu) for the last couple of years, if not the past decade.
The untrammelled greed and short-sighted avarice of overpaid investment
bankers, hedge-fund managers and their ilk may be a popular target, as
we try to muddle our way to even a vague understanding of mostly
incomprehensible credit-derivative products with seemingly innocuous
acronyms like CDO and CDS. More sophisticated analyses may focus on that part of Greenspan’s
edifice that Greenspan has himself now acknowledged was a poor
foundation: the ability to manage risk-allocation in a purely
self-regulating environment.
And fair enough, but ultimately the money
had to come from somewhere. Just as the Austrian-school of economists
(notably Hayek and von Mises) lamented the effects of cheap credit in
growing money supply at an unsustainable rate back in the late 1920s,
we’re seeing a similar backlash now. We’re becoming schoolmarmish as we cluck
and scold all this wanton excess even as we were the willing recipients
of all this cheap and plentiful credit. Our new houses, plasma TV
screens and new kitchens were made possible by the illusion – ours as
much as “theirs,” where “they” is the faceless elite of international
banking and credit – that risk could be redefined if only you have the
right packaging. Still stories need their villains, and fatcat bankers fit the bill nicely. Thus, for many it sticks in the craw to see so much money going to the very people who were, in their irresponsible credit and risk management practices, at least partly responsible for our current mess.
In fact, based on the experience of the 1930s, opening the money gates from central banks around the world to support the tottering balance sheets of failing banks and acquire the garbage assets that have put them in a parlous state is almost certainly the right thing to do. Governments are largely powerless to do anything about the psychology of its citizenry. But they can at least act to protect the solvency of those institutions which, through their collective lending practices, help determine the overall financial health of the economy. Bernanke’s 1983 study suggested that the US Federal Reserve – and indeed central banks around the globe – did not do enough to shore up the liquidity of the financial system. As a consequence, by the time the consumer crisis had taken hold, banks lost the ability to determine risk – intermediation as it is known. Economic recovery became almost impossible since economic growth requires a certain degree of willingness to embrace risk. I am unsure of the degree to which Mr. Bernanke and his cohorts have been reacting over the last 18 months with the events of the early 1930s in mind, but it certainly seems like they have been casting a scholarly glance backwards.
Pumping so much money into a financial system seems on the surface like absolving people and institutions from the consequences of their poor decision making and a violation of the cardinal principle of moral hazard. And that’s true. But as the banking crisis of 1930 showed, it is the lesser of two evils.
Keeping the financial system afloat is of paramount concern. In 1930, economists largely assumed that as bad debt worked its way through the system, credit would self-correct. As events showed, however, the scale of the economic contraction made nonsense of this kind of reasoning. I doubt the massive effort to spread liquidity into global financial markets will have any short-term effect. But the effort to prop up balance sheets is a good one, since it means that we are unlikely to see the kind of asset freeze that occured so quickly back in the early 1930s.
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