Recessions Caused by Banking Crises Are Different

by: James Picerno

Banking crises are old hat in capitalism, and much of what ails us these days is first and foremost a banking crisis. The question is whether that matters in diagnosing the cause, and the apparent solution for the recession du jour? It does…maybe.

Economic contractions brought on by a banking crisis must be distinguished from downturns born of what some might call the growth cycle's old age. In the latter, the central bank takes away the proverbial punch bowl in an effort to reduce the risk of inflation. An extended period of economic growth tends to elevate inflationary pressures, which compels central bankers to raise interest rates. Elevating the price of money, in turn, raises the risk of recession.

Of the two basic drivers of recession, the former describes the source of our current predicament. The missteps by the financial sector, in other words, planted the seeds of this downturn. Recessions born of banking crises aren't unprecedented, but they're relatively rare. Good thing, too, since the blowback is particularly difficult to solve, at least in a timely and obvious manner.

In a recession brought on by higher interest rates, the solution is usually one of reversing the process and thereby dispensing cheap credit to the system. But in a banking crisis, cheap credit doesn't offer its usual stimulating effects.

In the rush to find solutions, there's a temptation to ignore history, which may be one reason why recessions will always be with us. Consider that in an age long ago and far away, bankers extolled the virtues of their club. In that world, extending credit to would-be borrowers was the exception rather than the rule. Some complained that only the highest rated borrowers had access to loans. Whatever the virtues, and vices, of this clubby system, it didn't preclude the arrival of banking crises, or the recessionary effects thereafter. Witness the crisis of 1907, that gave us the 1907-1908 recession.

The 1907 calamity also inspired the Pujo hearings of 1912, which were designed to root out the evils of the "money trust," of which J. P. Morgan was the leading member. Out of these Congressional hearings came the "solution," a.k.a., the Federal Reserve, which was founded a year later, and general push to expand the possibilities of lending. In the course of subsequent decades, that lofty goal would be achieved on a level that seemed impossible in 1912.

Fast forward to 2009, when the world laments the fact that credit was extended every which way in years running up to the banking crisis of 2008. In those days of easy money, securing a loan was common, ordinary and frequent. For a time, all seemed right, and some argued that the country was a better place because democracy had finally come to the business of lending.

Now we know different, or at least we think we do. But what's striking in all of this, as we bemoan the decline and fall of banking standards that allowed virtually anyone and everyone to access the credit markets, is that we've come full circle from a century ago. In less than 100 years we've traveled from an era when credit was reserved for the wealthy and the connected to the early 21st century when, until recently, lending required little more than a pulse. The only thing that's remained constant is the banking crisis.

We should be humble about thinking we know how to prevent the next banking crisis. That doesn't mean we shouldn't try. But progress in finance comes slowly, if at all. Legislation changes, banking standards evolve, and the price of money fluctuates. Greed and fear, however, are still forever.