Tuesday, September 23, 2008

Have We Been Here Before?

(Before we begin, I wanted to just make a few things clear. I will try and explain this extraordinarily complex financial situation as simply as possible. I will provide plentiful links to definitions of perhaps unfamiliar words and concepts. I will strive to be as simple but as thorough as I can be. Any topic that will be raised in these next few posts could be a topic of volumes of writing and hours of discussion. Please leave your comments/questions/disagreements. I would be very interested to hear what you think).

Have we been here before? "Here," naturally, meaning in a financial situation that started out bad and seems to keep getting worse by the day?

Well, the answer is the ever-unsatisfying "yes and no."

Let's start with the "yes" part first.

Panics, Recessions and Depressions of Yesteryear

There have been ups and downs in general economic performance and the fortunes of the financial system ever since people started trading what they had for what they needed. That is when the ideas of supply, demand and prices first hoved into the human economic conscious. We will not go back that far, though, as the roots of today's problems are much closer to our own time.

Recessions and depressions, while subject to some semantic wrangling, are fairly well-defined concepts and have happened at various times in the past. Their occurrence is usually seen as part of the business cycle, the normal expansion and contraction that is typical of any modern market economy.

These peaks and troughs in the overall performance of the economy have happened in somewhat predictable patterns beginning in roughly the middle of the nineteenth century when the integrated, global economy that we live in today had its birth. As you can see from looking at historical patterns of the business cycle in the US, recessions happen fairly frequently. Depressions, which are recessions that last longer, happen less frequently.

These expansions and contractions have happened throughout our history, and the reason for their onset is always a little different. The Panic of 1873, for example, was caused by the failure of the largest bank in the US, coupled with the collapse of the Vienna Stock Exchange, both of which burst the post American Civil War speculative bubble (more on these later). This panic led to a long, worldwide depression, lasting from 1873 to around 1896. The hardest hit was Great Britain, who lost much of the edge in industrial production that they had held since the end of the 18th Century.

This is not, however, the historical case that people have been bringing up over the last week. That case is, of course, the Great Depression of the 1930's. While a full discussion of the causes of the Great Depression (and why it lasted so long in the US) is beyond the scope of this post, let us consider some of the large factors at play. It seems that the following were at least, in part, responsible:
  • The decision of several European countries to return to the gold standard at pre-WWI rates of exchange.
  • The expansion of the money supply in the 1920's which led to a credit-fueled economic boom.
  • The mismanagement of the aforementioned money supply by the Federal Reserve Bank.
  • Policy blunders on the part of both the Hoover and Roosevelt administrations that contributed to the contraction.
  • Wage rates that were not allowed to rise and fall with inflation, unemployment and prices.

As I said, there are others, but the above mentioned causes should serve our purposes.

We will deal with the meaning of all of this to us today at the end of the post. Now, on to...

Manias, Speculation, Bubbles and the Aftermath

Just like depressions and recessions, there has been financial speculation as long as anyone has invested in anything. Speculation is basically the buying and selling of an asset to make a quick profit. Speculators play a key role in any asset market as they provide liquidity and price discovery for all other players in that market.

The history of speculation comes replete with many speculative "manias" for certain assets and their boom and bust is somewhat similar to the above mentioned business cycle. People have speculated on everything from tulip bulbs in 17th Century Holland, shares in the South Sea Company in 18th Century Britain, railroad stocks in 19th Century America (and Britain too), and all of the stock crazes of more recent years (biotech stocks in the 1980's and Internet stocks in the 1990's).

What happens when these speculative bubbles "burst?" Do they cause depressions and recessions? In my opinion, they do not. It seems that they are a necessary, but not sufficient condition for a recession. Did the stock market "crash" of 1929 cause the Great Depression? No, because it was one of many conditions that interacted to cause the economic contraction (and was preceded by conditions that helped to make its effect even worse).

Did the dot.com crash of 2000-2001 cause the current financial problems. Here again, no, but it was one of the factors at play in making today's situation what it is and what it will be.

What happens if these disruptions in the market economy are so bad that the whole complex web of economic interactions faces either partial or total failure? Well, usually the answer is that nothing is "so bad" that it cannot be eventually dealt with through the normal operation of the marketplace.

There have been times, though, where markets have turned outside themselves (or were set upon by outside forces) who felt that their failure was too dangerous to risk. In the last, oh, 100 years this has happened a few times.

The Panic of 1907, which saw declines in the stock market, contraction of credit and a profound loss of liquidity for banks was eventually dealt with when J.P. Morgan and a consortium of bankers backed losses, provided capital and saved the system from collapse.

The bail-out came in a different form during the Savings and Loan crisis of the 1980's. While not exactly a speculative bubble, the case of the bail-out is instructive. This time, it was the Federal Government who spearheaded the bailout of the S&L industry, primarily with the provisions of the Financial Institutions Reform, Recovery and Enforcement Act of 1989. Here, Uncle Sam created new deposit insurance, took on and disposed of the assets of failed S&L's and created greater oversight for thrifts and their lending procedures.

The case of Long-Term Capital Management is as complex as the trading algorithyms that they used. Read about it here. Basically, it was a case of highly-leveraged traders and mathematical whiz-kids who had a system that should have worked perfectly, but it didn't, they threw good money after bad and it all fell down. I may have more to say about this case later on.

Why We Haven't Been Here Before

I said a little earlier that while some of the instances of these financial collapses, panics and manias of the past may seem eerily like what is up these days, one should be careful before thinking that it is a case of history repeating itself.

The fact is that history never really does this. Oh yes, things that happen today may be similar to the past, but the conditions are different, the people involved are different and the world that they inhabit is different.

History is a great tool for understanding how factors interacted with each other in the past, how people reacted and how these broad developments helped to shape their world and (in time) ours. History is a poor tool for forcasting the future or trying to transfer occurrences of the past in whole cloth to the present day. History, in other words, is a good teacher but a bad prognosticator.

For Next Time

Now that we have a little historical perspective and some basic terminology down, we can proceed to picking apart the current financial situation (the Panic of 2008?) Much that we discussed today will be instructive in understanding our current woes. Many of the outcomes of the past helped to shape the financial system that gave birth to these problems. Actually, one of the key starting points for this came in the "bursting" of the aforementioned dot.com bubble in 2000-2001.

It is there that we will begin next time.

In the meantime, please do check out some of the links provided above. Additionally, I can recommend a few great sources on the history of bubbles and speculation. On bubbles, crazes and manias, there is still no better book than Charles Mackay's 1841 classic Extraordinary Popular Delusions and the Madness of Crowds. You can actually read the whole book here.

On the history of speculation in general, there is the very good and readable Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor. Also good here is Charles Kindleberger's 1978 (modern) classic Manias, Panics and Crashes.

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