The panic is over
In 1999, Edward Chancellor wrote a wonderful book called “Devil Take The Hindmost,” which I recommend to anyone who is interested in the history of bubbles, financial speculation, and market panics. In it, Chancellor traces the origins of speculative manias to as far back as Ancient Rome. His book recounts previous speculative periods like the infamous South Sea Bubble of the early 1700s and the railway mania of the 1840s as well as the Crash of 1929 and the recent bubble in 1990s Japan.
Yesterday, Chancellor turned his keen insight to the present market panic and has some very thoughtful words to say that bear repeating.
The financial panic we have been living through has much in common with the great banking panics of the past: rumours of foundering financial giants, concerns about counterparties, the shepherding of cash and flight to the highest quality and most liquid credit instruments, the dumping of riskier assets regardless of price, international contagion and, above all, a heightened sense of the fragility of a weakened financial system. Yet this panic will pass, just like its predecessors.
Bank panics always have the same origin. “Every genuine business panic springs from the same root, which is rank speculation,” wrote one Victorian commentator. Thomas Tooke, the early 19th century merchant and author, ascribed the British crisis of 1793 to “a great and undue extension of the system of credit and paper circulation”. A year earlier, Thomas Jefferson, observing the first financial collapse in the independent United States, noted that “our paper bubble has burst”.
In July, I echoed these thoughts when I said:
Loans on credit also create the boom-bust business cycle. In our fractional reserve deposit banking system, banks must keep on hand only a portion of the money we deposit. The rest is lent out as credit. Therefore, if all depositors were to rush to the bank to redeem their deposits, the bank would not have enough cash on hand and would be declared insolvent. This is what happens in a bank run. To avoid a run, banks must maintain the confidence of depositors by acting prudently and cautiously in extending credit. If not, they risk insolvency.
The problem is that human nature steps in; as the business cycle progresses, the banks lend more and more money. Naturally, some of those loans are ‘bad’ loans i.e., the debtor cannot pay back the full principal at the required time. The banks must account for these bad loans in their loan loss reserves.
However, at some point, when the credit cycle has progressed too far, one of two things occurs:
- The economy ‘overheats’ and inflation starts to rise. Whispers start circulating that the central bank will raise interest rates and that inflation is spiraling out of control. The central bank does increase interest rates and many loans that looked good in a lower interest rate environment start to go sour.
- Banks simply start lending to too many questionable debtors and more loans go bad than anticipated.
As rumors circulate that this bank or that bank has been lending imprudently, the banks dig in their heels and pull back. Interest rates go up, credit contracts, and the economy goes into recession.
This is the business cycle. It is a natural part of our capitalist system and it is entirely created by the extension of credit.
–The ECB is right and the Fed is wrong
In essence, credit and the business cycle are at the core of the crisis we are experiencing. Market participants, encouraged by irresponsibly low interest rates earlier this decade, expanded credit in an unsustainable way to dubious borrowers. We are now in a period of credit revulsion akin to the disdain one feels for even the sight of food after a particularly aggressive eating binge.
Our binge and the attendant excesses were quite large and, thus, the economic diet too will be need to be quite large. One reason the stock market is in steep decline just two days after an historic rise is that the realization is setting in on market participants that the workout phase of this downturn is far from over.
Chancellor notes that:
“the current panic will pass as others have done beforehand. This does not mean the aftermath will be pleasant for the wider economy. Emergency measures may allay the panic but they cannot correct the credit excesses that are the root cause of the crisis.”
One could liken the economy to a critically injured patient brought into the emergency room. The doctors have done their best to stop the bleeding and relieve the acute signs of trauma. But, now the patient is in intensive care and the chronic signs of trauma and injury are still very real. The doctors are, therefore, well-advised to continue to monitor the patient and provide medicinal relief when needed.
Panic passes but the causes remain – Edward Chancellor, FT
Devil Take The Hindmost – Edward Chancellor