Tuesday, July 29, 2014
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The Perils of Financial Historicism

Every financial crisis is inherently unknowable – before it occurs, and as it occurs. By contrast, we understand past crises very well. Accountants go over the books, the participants tell their tales to the newspapers (or sometimes before a judge), politicians explain why they are sorting out a mess, and in the end historians put together a story.

Because the past is knowable, the best way of understanding a current crisis is to search for a model in past experiences, even those that are long past. But which is the right template?

Often the choice depends less on a rational assessment of similarities and differences than on gut feelings, proclivities to optimism or pessimism, or political orientation. Currently, two dates are circulating widely, 1907 and 1931.

At the beginning of the current credit crunch, many historically minded people picked 1907 as the key precedent. Not only is it an arithmetically neat 100 years in the past, but it also looked like an attractive parallel. The crisis of 1907 was both immediately devastating, provoking a massive but short economic downturn, and, as it turned out, easily resolved.

The 1907 panic started in the United States, owing to a rise in interest rates as farmers in the West were paid for their crops and financial scandals in New York that seemed to implicate a large financial institution, the Knickerbocker trust.

Suddenly, as today, even big banks did not trust each other. The breakdown was fundamentally a liquidity crisis, and liquidity was easily restored in several ways: the New York banks issued their own liquidity through a clearing house; one massively powerful financial institution, J.P. Morgan, bought up collapsing shares, and thus reversed a market panic and a scramble for liquidity; and European central banks supplied gold to the American market.

The obvious lesson of 1907 that Americans learned was that central banks were the best placed institutions to restore liquidity in a financial panic, and, in the longer run, monetary reform gave the US its own central bank, the Federal Reserve, by 1914. So 1907 became a comforting mantra in times of financial stress: a crisis cannot happen as long as the central bank understands the problem of liquidity.

There are modern parallels. The Fed and the European Central Bank have recently pumped massive amounts of liquidity into the global financial system. Strategically placed private institutions have done their part to shore up confidence. Goldman Sachs, for example, has made a point of publicly buying endangered assets in its Global Equities Opportunity Fund.

The darker parallel is to the Great Depression of the 1930’s, when no amount of liquidity helped. This is the historical analogy drawn by those who want governments to do more, particularly banks that feel vulnerable and desperately need a public bailout. In August 2007, some German banks, at the earliest signs of difficulty because of their exposure to US sub-prime mortgages, started to talk only of 1931.

In the Great Depression, bank collapses made the downturn far worse. They were contagious across national frontiers. Governments not only needed to help by providing a combination of public assistance and new legislation guaranteeing deposits, but also were called on to shield their constituencies from destabilizing international influences.

This nationalist-minded rhetoric has returned in the financial crisis of 2007. Germans do not see why they should be vulnerable because of poor quality mortgage lending in American inner cities. Depositors with the British bank Northern Rock blame American developments for the credit turbulence that made it impossible for the bank to continue to fund its lending.

Neither of these apparent historical parallels is convincing. We are not living in 1907, when the gold standard limited the ability of central banks to supply additional liquidity. Nor, following the fastest five-year period of economic growth in human history, are collapsing prices endangering the financial system, as they did during the Great Depression.

Today, the responses to the 1907 and 1931 crises would only make matters worse. The continuous injection of liquidity would imply a greater likelihood of renewed asset bubbles in housing, equities, or modern art. Government stabilization of the banking system can either be international, provoking complaints by outraged taxpayers about subsidizing others, or national, but only at the cost of greatly extended regulation of capital movements. Both courses are unnecessary.

If today’s credit crunch has historical parallels, they are closer to nineteenth-century “normal crises” like 1837, 1847, or 1857. In those panics, financial innovation caused uncertainty and nervousness, but also induced an important and beneficial learning process. The financial institutions that survived the crises went on to play a crucial role in pushing further development, and they had enhanced reputations because they withstood a crisis.

Sometimes monetary and fiscal authorities have an obligation to ignore the wilder historical parallels and look at a broader picture. Sometimes, too, the best response to a crisis is this: don’t just do something; stand there and do nothing.

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