Is the Panic 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.

On Tuesday, 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 on my blog Credit Writedowns ("The ECB is right and the Fed is wrong"):

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.

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.

Related posts

• The ECB is right and the Fed is wrong
• Finding a bottom
• The Road to Revulsion

Source

• Panic passes but the causes remain - Edward Chancellor, FT

Related books

• Devil Take The Hindmost - Edward Chancellor

Comments

[Smarty_Pants:]

Sadly, the medicine is what caused the illness in the first place.

2008 Oct 16 10:21 AM

[ashizashiz:]

You are wrong. Your "Intensive Care" analogy is fatally flawed. WE are NOT experiencing a credit "revulsion": revulsion implies irrational thinking, which in itself implies choice. This is not a crisis of confidence and it is not a crisis of choice...it is a crisis of DEBT.

For centuries, there has been no distinction between MONEY and DEBT. In fact, without debt, as we all know, there is no money, no financial system. The system that, like a parasite, has lived off of its host and made a few people stinking rich while using duplicity, violence and murder to have its way in the world CANNOT BE REFORMED. It cannot. It either has to be thrown away and we have to start from scratch, or it has to continue ad infinitum until we have Warren Buffet the Quadrillionaire, the DOW @ 100,000, and global debt of 14 Septillion dollars. (14 Septillion = 14,000,000,000,000,000... dollars, in round figures of course).

But to have this continued growth, there can be NO MARGIN CALLS, no withdrawals from banks, no fiat currency....simply debt...and of course this CANNOT work. I know, capital "A" Absurd for me to even play this little game. Debt is only "money" if people (a) believe that it is money and (b) if people can and DO service their debt. AND THAT IS WHY THIS CRISIS IS UNLIKE ANY WE HAVE SEEN BEFORE. This time, people are coming to the realization that debt actually ISN'T money. People are slowly beginning to realize that our global financial system is a usurious system in which bankers and other folks in the 'money' business are making trillions of dollars on the backs (that is, debt) of the common folk. You and me.

2008 Oct 16 11:57 AM

[John Lounsbury:]

Edward, you merely scratch the surface. I'll discuss more below.

Dan, you miss the point about revulsion toward credit. The revulsion is there on the part of the lenders. You are correct that the borrowers have no choice (little choice?), but lenders do have a choice and I believe they will chose to restrict credit. Yes, governments around the world are pouring out hundreds of billions (eventually trillions?) of new money for equity in the banking system. But much of this will be used to retire the pyramid of paper debt and increase the reserves so that the banks can stay afloat.

In other words, all this money creation will not fuel inflation because most of it will disappear into a black hole. We are now printing government backed fiat currency to replace the private sector fiat currency (credit derivatives) that were created over the past decade. World governments are not creating currency that will increase the money in circulation; they are simply replacing some of the money created in the private sector that has now proved to be worth much less than thought just a couple of years ago.

Bottom line: financial instruments are deflating. Govenments are preventing the total collapse of the financial system by shoring up the balance sheets of banks. During the process, credit will remain tight and other assets will continue to deflate, real estate and stocks among them.

How long will this deflation last? As long as new money is disappearing to replace the old money (credit) we lived on for so many years. The most optimistic speculate about how many months. The most pessimistic speculate about how many years. Personally, I don't have a good guess, but a wild stab would be somewhere between six months and three years. Whatever the time frame, stocks are likely to put in a secular bear market bottom at least six months before the deflationary period ends. The stock market will continue the historic pattern of being forward looking.

2008 Oct 16 12:54 PM

[Edward Harr...:]

jlounsbury59,

yes, you are right. I only was able to scratch the surface - There is a limit to how much one can write in one post. That said, you should visit my site to see other posts of a similar vein. You might find this one from June particularly relevant given your viewpoint.

www.creditwritedowns.c...

I happen to believe this recession will be deep and long (more than 12 months, probably much, much longer)

Cheers.

Edward

2008 Oct 16 01:58 PM