By David Warsh :
So much for the first two depressions, the one that happened in the twentieth century, and the other that didn't happen in the twenty-first. What about that third depression? The presumptive one that threatens somewhere in the years ahead.
Avoiding the second disaster, when a full-blown systemic panic erupted in financial markets in September 2008 after fourteen months of slowly growing apprehension, turned on understanding what precipitated and exacerbated the first disaster, the Great Depression of the 1930s.
By the same token, much will depend on how the crisis of 2007-08 comes to be understood by politicians and policy-makers in the future.
The panic of '08 wasn't described as such at the time - it was all but invisible to outsiders, and understood by insiders only at the last possible moment.
It occurred in a collateral-based banking system that bankers and money-managers had hastily improvised to finance a thirty-year boom often summarized as an era of "globalization."
The logic of this so-called "shadow banking system" has slowly become visible only after the fact.
The panic was centered in a market that few outside the world of banking even knew to exist. Its very name - repo - was unfamiliar. The use of sale and repurchase agreements as short-term financing - some $10 trillion worth of overnight demand deposits for institutional money managers, insured by financial collateral - had grown so quickly since the 1980s that the Federal Reserve Board gave up measuring it in 2006.
The panic led to the first downturn in global output since the end of World War II, and the ensuing political consequences in the United States, Europe, and Russia have been intense.
But the banking panic itself was the more or less natural climax to a building spree that saw China's entry into the world trading system, the collapse of the USSR, and many other less spectacular developments - all facilitated by an accompanying revolution in information and communications technology.
Gross world product statistics are hard to come by - the concept is too new - but however those years are understood, as one period of expansion of world trade or two, punctuated by the 1970s, growth since the trough of the Great Depression is unique in global history.
The much-ballyhooed subprime lending was only a proximate cause. It was a detonator attached to a debt bomb that fortunately didn't explode, thanks to emergency lending by central banks, backed by their national treasuries, that alleviated the fear of irrational ruin.
Instead of Great Depression 2.0, the loans were mostly repaid.
But what had occurred was almost completely misinterpreted by both the Bush and Obama administrations. What happened is still not broadly understood, even among economists.
Let me briefly recapitulate the story I have been telling here since May - mainly an elaboration of the work of a handful of economists involved in the financial macroeconomics project of the National Bureau of Economic Research.
Panics We Will Always Have With Us
Banks have been a fixture of market economies since medieval times. Periodic panics have been a feature of banking since the seventeenth century, usually occurring at intervals of ten to twelve years. Panics are always the same: en masse demands by depositors - in modern parlance, by holders of bank debt - for cash.
Panics are a problem because the cash is not there - most of it has been lent out, many times over, in accordance with the principles of fractional banking, with only a certain amount kept in the till to cover ordinary rates of withdrawal.
In the eighteen century, Sir James Steuart argued for central banks and government charters. His rival Adam Smith advocated less invasive regulation, consisting of bank capital and reserve requirements and, having ignored Steuart, won the argument completely, as far as economists were concerned. Bankers were less persuaded. After the Panic of 1793, the Bank of England began lending to quell stampedes.
Panics continued in the nineteenth century and, as banks grew larger and more numerous, became worse. After the Panic of 1866 shook the systems, former banker Walter Bagehot took leave from his job as editor of The Economist to set straight the directors of the Bank of England. In Lombard Street: A Description of the Money Market, he spelled out three basic rules for preventing them panics from getting out of hand: lend freely to institutions threatened by withdrawals, at a penalty rate, against good collateral. Thereafter, troubled banks sometimes closed, but panics in the United Kingdom ceased.
Panics continued in the United States. The National Banking Acts of 1863 and 1864 were supposed to stop them; they didn't. There were panics in 1873, 1884 and 1893. At least the statutes created a national currency, backed by gold, and the Office of the Comptroller of the Currency to manage both the paper currency and the banks.
Since then, three especially notable panics have occurred in the U.S. in the last hundred years - in 1907, in 1930-33, and in 2007-8.
The 1907 panic began with a run on two New York City banks, then spread to the investment banks of their day - the new money trusts. The threatened firestorm was quelled only when the New York Clearing House issued loan certificates to stop the bank run and J.P. Morgan ( JPM ) organized the rescue of the trusts.
The episode led, fairly directly, to the creation in 1913 of the Federal Reserve System - what turned out to be a dozen regional banks in major banking cities around the country, privately owned, including an especially powerful one in New York, and a seven-member board of governors in Washington, D.C. appointed by the president.
Legislators recognized that creating the Fed amounted to establishing a fourth branch of government, semi-independent of the rest, and a great deal of care and compromise went into the legislation. Under the leadership of Benjamin Strong , president of the Federal Reserve Bank of New York, who had served as Morgan's deputy in resolving the 1907 crisis, and who enjoyed widespread confidence in both banking and government circles as a result, the Fed got off to a good start.
In the Panic of 1914, at the outbreak of World War I, banks were able to issue emergency currency under the Aldrich-Vreeland Act; the Fed was not yet functioning. The new central bank managed its policies adroitly enough in the short, sharp post-war recession of 1920-21 to gain a measure of self-confidence. In 1923, it began actively managing the ebb and flow of interest rates through "open market operations," buying and selling government bonds for its own account.
Then Strong died, in 1928, leaving a political vacuum. That same year, disputatious leaders within the Fed, its governors in Washington and its operational center in New York, and their counterparts in the central banks of Britain, France and Germany, began to make a series of missteps that, cumulatively, may have led to the Great Depression. Investment banker Liquat Ahamed has argued as much in Lords of Finance: The Bankers Who Broke the World , drawing on a century of economic and historical research.
Starting in January 1928, the New York Fed stepped sharply on its brakes, hoping to dampen what it regarded as excessive stock market speculation. Instead the market surged, then crashed in October 1929. A sharp recession had begun.
A series of bank failures began, but the methods by which the industry had coped with such runs before the central bank was established were held in abeyance, awaiting intervention by the Fed. Instead of acting, the Fed tightened.
Twice more, in 1931, and in early 1933, waves of panic swept segments of the banking industry around the country with corresponding failures of hundreds of banks - everywhere but New York. (There was no deposit insurance in those days.)
Each time the Fed stood by, declining to lend or otherwise ease monetary stringency. Meanwhile Herbert Hoover set out to balance the federal budget. By March 1933, banks in many states had been closed by executive order.
Franklin Roosevelt defeated Hoover in a landslide in November 1932. The subsequent March, Roosevelt and a heavily Democratic Congress began the New Deal. (Inauguration of the new president was subsequently moved up to January.) With unemployment rates reaching 25 percent and remaining stubbornly high, the panics of the early '30s were quickly forgotten. In any event, they had ceased.
Economists of all stripes offered prescriptions. Finally, in 1936, John Maynard Keynes, in The General Theory of Employment, Interest and Money , dramatically recast the matter. Because wages would inevitably be slow to fall, an economy could become trapped in a high-unemployment equilibrium for lengthy periods of time. Only government could intervene effectively, providing fiscal stimulus to create more jobs, returning a stalled economy to a full-employment equilibrium.
Keynesian ideas gradually conquered the economics profession, especially after they were restated by Sir John Hicks and Paul Samuelson in more traditional terms. Soon after World War II, the new doctrine was deployed in the industrial democracies of the West. Fiscal policy, meaning raising and lowering taxes periodically, and manipulating government spending in between, would be the key to managing, perhaps even ending, business cycles. The influence of money and banking were said to be slight.
Starting in 1948, Milton Friedman and Anna Schwartz, two young economists associated respectively with the University of Chicago and the NBER, began a long rearguard action against the dominant Keynesian orthodoxy. It reached a climax with the publication, in 1963, of A Monetary History of the United States, 1867-1960 , a lengthy statistical study of the Fed's conduct of monetary policy. Its centerpiece was a reinterpretation of the Great Depression.
The Fed, far from having been being powerless to affect the economy, Friedman and Schwartz argued, had turned "what might have been a garden-variety recession, though perhaps a fairly severe one, into a major catastrophe," by permitting the quantity of money to decline by a third between 1929 and 1933.
Peter Temin, economic historian at the Massachusetts Institute of Technology, took the other side of the argument. Shocks produced by World War I were so severe that, exacerbated by commitments to an inflexible gold standard, a dozen years later, they caused the Depression. Central banks could scarcely have acted otherwise.
The argument raged throughout the '70s. By the early '80s, a young MIT graduate student named Ben Bernanke concluded that Friedman was basically correct: monetary policy, especially emergency last-resort lending, was very important. He and others set out to persuade their peers. By a series of happy coincidences, Bernanke had been in office as chairman of the Fed just long enough to recognize the beginning of the panic for what they were in the summer of 2007. And so fifty years of economics inside baseball was swept away in a month of emergency lending in the autumn of 2008. Great Depression 2.0 was avoided. Friedman - or at least Bagehot - had been right.
This is a very different story than the one commonly told. More of that in a final episode next week.
Meanwhile, even this brief account raises an interesting question. How was it that the United States enjoyed that seventy-five-year respite from panics - Gary Gorton calls it "the quiet period" - in the decades after 1934?
Why We Had the Quiet Years
With respect to banking, four measures stand out among the responses to the Crash of 1929 and the subsequent Great Depression:
* President Roosevelt explained very clearly the panic that had taken hold in the weeks before his inauguration in his first Fireside Chat, " The Banking Crisis ," and why he had declared a bank holiday to deal with it. He had taken the U.S. off the gold standard, too, but didn't complicate matters by trying to explain why. As Gorton has pointed out, Roosevelt was careful not to blame the banks.
… Some of our bankers had shown themselves either incompetent or dishonest in their handling of the people's funds. They had used the money entrusted to them in speculations and unwise loans. This was, of course, not true in the vast majority of our banks, but it was true in enough of them to shock the people for a time into a sense of insecurity and to put them into a frame of mind where they did not differentiate, but seemed to assume that the acts of a comparative few had tainted them all. It was the Government's job to straighten out this situation and do it as quickly as possible. And the job is being performed.
* The Banking Act of 1933, known as the Glass-Steagall Act for its sponsors, Sen Carter Glass (D-Virginia) and Rep. Henry Steagall (D-Alabama), tightly partitioned the banking system, relying mainly on strong charters for commercial banks of various sorts. Securities firms were prohibited from taking deposits; banks were prohibited from dealing or underwriting securities, or investing in them themselves. (The McFadden Act of 1927 already had prohibited interstate banking.)
* Congress established the Federal Deposit Insurance Corporation to oversee the deposit insurance provisions of the 1933 Banking Act. Small banks were covered as well as big ones, at the instance of Steagall, over the objections of Glass.
* Former Utah banker Marinner Eccles, as chairman of the Federal Reserve Board, re-engineered the governance of the Fed as part of the Banking Act of 1935, over the vigorous opposition of Carter Glass, who had been one of the architects of the original Federal Reserve Act. Eccles wrote later:
A more effective way of diffusing responsibility and encouraging inertia and indecision could not very well have been devised.
Authority for monetary policy was re-assigned to the Board of Governors in Washington, in the form of a new 12-member Federal Open Market Committee, rather than left to the regional bank in New York. The power of the regional banks was reduced, and the appointment of their presidents made subject to the approval of the Board. Emergency lending powers were broadened to include what the governors considered "sound assets," instead of previously eligible commercial paper, narrowly defined. The system remained privately owned, and required no Congressional appropriations (dividends from its portfolio of government bonds more than covered the cost of its operations), but its relationships with the Treasury Department and Congress remained somewhat ambiguous.
A fifth measure, the government's entry into the mortgage business, has a cloudier history. The Federal Housing Act of 1934 set standards for construction and underwriting and insured loans made by banks and other lenders for home construction, but had relatively little effect until the Reconstruction Finance Corporation established the Federal National Mortgage Association ( FNMA ) (or Fannie Mae) in1938, to buy mortgage loans from the banks and syndicate them to large investors looking for guaranteed returns. With that, plus the design of a new thirty-year mortgage requiring a low down payment, the housing market finally took off. As chairman of the Fed, Eccles pleaded with bankers to create the secondary market themselves, but without success.
Lawyers immediately began looking for loopholes. By 1940 they had found several, resulting in the passage of the Investment Company Act, providing for federal oversight of mutual funds, then in their infancy. Eight years later, the first hedge fund found a way to open its doors without supervision under the 1940 Act - as a limited partnership of fewer than 100 investors.
By the 1970s, many financial firm were eager to enter businesses forbidden them by the New Deal reforms. The little-remembered Securities Acts Amendment of 1975 began the process of financial de-regulation with the seemingly innocuous aim of ending the 180-year-old prohibition of price competition among members of the New York Stock Exchange. It was a response to an initiative undertaken by the Treasury Department in the midst of the Watergate scandals of the Nixon administration, and signed into law by President Gerald Ford, Deregulation continued apace under President Jimmy Carter, and swung into high gear with the election of President Ronald Reagan. It reached its apex with the repeal of the key provisions of the Glass-Steagall Act in 1999.
As of 1975, financial innovators had been encouraged to experiment as they pleased, subject mainly to the discipline of competition. The moment coincided with developments in academic finance that revealed whole new realms of possibility. Fed regulators scrutinized the new developments at intervals. Investment banker (and future Treasury Secretary) Nicholas Brady headed a commission that examined relationships among commodity and stock exchanges after the sharp break in share prices in 1987. Economist Sam Cross studied swaps for the Fed. New York Fed president Gerald Corrigan undertook a more wide-ranging study of derivatives. Objections, including those of Brooksley Born , chairman of the Commodity Futures Trading Commission from 1996-99, were swept aside. An extensive new layer of regulation was put into place by the Sarbanes-Oxley Act of 2002, after the collapse of the dot.com bubble and the corporate scandals of 2001, Enron, WorldCom and Tyco International, but mostly these had to do with corporate accounting practices and disclosure. The vast new apparatus of global finance worked pretty well, until unmistakable signs of stress began to show in the summer of 2007.
It will be years before the outlines of the seventy-five years between 1933, the trough of the Great Depression, and 2008, the peak of the more-or-less uninterrupted global expansion that began in '33 (making allowances for World War II and the '70s, when the U.S. drifted while Japan and other Asian economies grew rapidly) come into focus. Yet a few basic facts about the period are already clear. Innovation was crucial, in finance as in all other things, especially information and communications technologies. Competition between the industrial democracies and the communist nations was a considerable stimulant to development. Banking and economic growth were intimately related, perhaps especially after1975. And the dominant narrative furnished by economic science, the history of the business cycle compiled by the NBER, while valuable, is of limited usefulness when it comes to interpreting the history of events. Additional yardsticks will be required.
The New New Deal - Not
How did the Practicals do this time, measured against the template they chose, the New Deal of Franklin Roosevelt? Not very well, I am sorry to say.
Certainly the Fed did much better than it had in the years between 1928 and 1934. Decisions in its final years under Chairman Alan Greenspan will continue to be scrutinized. And no one doubts that Bernanke made a slow start after taking over in February 2006. But from summer of 2007, the Fed was on top at every juncture. The decision to let Lehman Brothers fail, is likely to be the chief topic of conversation in the stove-top league when his first-person account, The Courage to Act , appears next week. It will still be debated a hundred years from now. If Lehman had somehow been salvaged, some other failure would have occurred. The panic happened in 2008. Bernanke, his team, and their counterparts abroad, were ready when it did.
The Bush administration, too, did far better than Hoover. Treasury Secretary Henry Paulson was not so good in the thundery months after August 2007, when he pursued a will-o'-the-wisp he called a " super SIV (structured investment vehicle)", modeled on the private-sector resolution of the hedge fund bankruptcies that accompanied the Russia crisis of 1998. And it can't be said that the planning for a "Break-the-Glass" reorganization act that Paulson ordered in April produced impressive results by the time it was rolled out as the Troubled Asset Relief Program in September. But Paulson's team improvised very well after that. Bernanke and Paulson, Bush's major post-Katrina appointments, as well as the president himself, with the cooperation of the Congressional leadership, steered the nation through its greatest financial peril in 75 years.
The panic was nearly over by the time Obama took office.
In retrospect, the Obama admiration seems to have been either coy or obtuse in its first few months. Former Treasury Secretary Lawrence Summers and Robert Rubin, the man he had succeeded in the job, formerly of Goldman Sachs and, by then, vice chairman of Citigroup, formally joined the Obama campaign on the Friday that the TARP was announced. (The connection to Rubin was soon severed.)
Summers, like the rest of the economics profession, began a journey of escape from the dogma he had learned in graduate school, which held that banking panics no longer occurred. Upon leaving office, in a conversation with columnist Martin Wolf, of the Financial Times , Summers hinted at how his thinking had changed when he told an audience at a meeting of the Institute for New Economic Thinking at Bretton Woods, N.H., in March 2011:
I would have to say that the vast edifice in both its new Keynesian variety and its new classical variety of attempting to place micro foundations under macroeconomics was not something that informed the policy making process in any important way.
Instead, Summers said, Walter Bagehot, Hyman Minsky, and, especially Charles Kindleberger had been among his guides to "the crisis we just went through."
But Summers made little attempt that day to distinguish between the terrifying panic that occurred the September before Obama took office, and the recession that the Obama administration had inherited as a result. Nor did the accounts of Summers' tenure subsequently published by journalists Noam Scheiber , Ron Suskind , and Michael Grunwald make clear the extent to which the panic had been a surprise to Summers. Schooled to act boldly by his service in the Treasury Department during the crises of the '90s, he did the best he could. At every juncture, Summers remained a crucial step behind Bernanke and Geithner, the men he hoped desperately to replace.
The result was that Obama's first address about the crisis, to a joint session of Congress, in February 2009, was memorable not so much for what the president said as for what he didn't.
I intend to hold these banks fully accountable for the assistance they receive, and this time they'll have to fully demonstrate how taxpayer dollars result in more lending for the American taxpayer. This time, CEOs won't be able to use taxpayer money to pad their paychecks or buy fancy drapes or disappear on a private jet.
But there was no matter-of-fact discussion of the panic of the autumn before the election, in the manner of Franklin Roosevelt; no credit given to the Fed (and certainly none to the Bush administration); and not much optimism, either. The cost of inaction would be "an economy that sputters along not for months or years, perhaps a decade," Obama said. After an initial "stimulus" - as opposed to the "compensatory spending" of the New Deal - of the $819 billion American Recovery and Reinvestment Act, inaction is exactly what he got. The loss of the Democratic majority in the House in the Tea Part election of 2010 only made the impasse worse. Yet the economy recovered.
Congress? Many regulators and bankers contend that the thousand-page Dodd Frank Act complicated the task of a future panic rescue by compromising the independence of the Fed. Next time the Treasury Secretary will be required to sign off on emergency lending.
Bank Regulators? Some economists, including Gorton , worry that by focusing on its new "liquidity coverage ratio" the Bank for International Settlements, by now the chief regulator of global banking, will have rendered the international system more fragile rather than less by immobilizing collateral.
Bankers? You know that the young ones among them are already looking for the Next New Thing.
Meanwhile, critics left and right in the U.S. Congress are seeking legislation that would curb the power of the Fed to respond to future crises.
So there is plenty to worry about in the years ahead. Based on the experience of 2008, when a disastrous meltdown was avoided, there is also reason to hope that central bankers will once again cope. Remember, though, as the Duke of Wellington said of the Battle of Waterloo, it was a close-run thing.
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