The events we are living through now will be remembered and studied in the decades to come. After it initially appeared that financial hemorrhaging had been staunched, in rapid succession long-standing titans of American finance -- Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, and more likely than not Washington Mutual and Wachovia Bank -- all have failed in one way or another. The Bush Administration has demanded that Congress authorize it to go "all in" with taxpayer $Trillions to attempt to rescue of the entire financial system: the stock, bond, and money markets.
In this post I compare and contrast our crisis with the Great Crash of 1929 and its aftermath. This is a Major Economic Event, but it is different from 1929. I suggest that it is too late to save both the Wall Street financial economy or the Main Street everyday economy. At this very moment, I believe, we are on the verge of a catastrophic choice that will kill Main Street without saving Wall Street.
The stock indices declined over 10% in the 2 weeks just past. In one day alone last week, gold shot up in price 10%. Yesteday Oil, which had briefly been under $100 again, exploded $25 in price in a single day. A ten year treasury bond last Monday fetched 3.30% interest -- the lowest save one week in 40 years. Last Wednesday a 3 month treasury bill fetched 0.06%, that is 6 cents for a $100 investment on an annual basis, meaning investors will willing to get paid essentially nothing just for the belief of safety. Professor Paul Krugman had a chilling, two-word description: "Liquidity Trap." There is also evidence that a run on "money market" accounts began, after 2 of them slipped from their $1 peg. More wealthy investors may have begun a run on hedge funds.
The world's up and coming economic superpower, China, through its party organ, the People's Daily, openly called for a non-dollar based international economy. Yesterday Vladimir Putin of Russia joined in that call.
Ordinary Americans looked at the retirement balances in their 401K plans and feared that they would never be able to stop working.
This may not be Economic Armageddon, but it certainly appears to be Financial Armageddon. In addition to Prof. Krugman, some excellent commentary has appeared from the ever-levelheaded Calculated Risk and Prof. Mark Thoma, both of which I highly recommend to you.
As somebody who almost two years ago began to write that the "diffused risk" of structured finance could easily transform into "systemic risk", and over a year ago described the period we have entered as an old fashioned "Panic" or "Bust" that would unfold in "s l o w m o t i o n", (for example, here, here, here, here, here, here, here, here, here, here, here, and here), describing it as a slow, grinding, multi-year destruction of debt to come, this week is certainly one of the particularly bad sudden periods that I knew had to be embedded within that traumatic event, an event that I believe still has 3-5 years to go before it is complete, and at the end of which both America and the world will seem quite different places. I wanted to share a "Big Picture" overview of how this Event is similar to and different from the Great Crash of 1929.
I knew the "bust" would occur in slow motion because so much momentum towards inflation was built into the system, that the deflationary forces of a credit collapse would only emerge after the old order was vanquished, kicking and screaming the whole way down. In fact I still suspect there will be a brief "respite" caused by lower inflation in gas and food by the end of this year, much as a drowning man might briefly bob to the surface and catch a breath of air before sinking again. After that, it is beginning to appear that the next chapter of the Slow Motion Panic will unfold in terrible earnest in 2009.
But let me step back and compare this period with the unfolding of the Great Depression, for what is happening now is in a number of significant ways quite different, and very susceptible I hope to competent and committed public action aimed at limiting the damage.
As I described earlier, what characterizes what I have called "The Panic of 2008" is:
- (1) declining asset prices (in stocks and housing),
- (2) increased imported inflation,
- (3) wage stagnation, and
- (4) the possibility of a "liquidity trap" that briefly emerged last week.
At the same time, I have continually pointed out that, ex-housing, the "real" economy on Main Street America has not worsened very much at all in 2008. In this respect the "Panic of 2008" is fundamentally different from the Great Crash of 1929.
In 1929 and 1930, as I have described in several prior diaries, it was the Main Street economy which declined first, beginning in June 1929. In that month inflation gave way to deflation, and consumers began to slow their purchases of goods. Meanwhile the financial economy, typified by the stock market, continued to roar ahead until September. While in our economy, the chief engine of the credit binge was a spectacular housing bubble that is still collapsing, the 1920s credit bubble primarily focused on "installment purchases" of cars, radios, and household furniture and appliances which had a draconian clause that allowed repossession if the consumer missed even one monthly payment. Thus, when economic conditions turned in the summer of 1929:
[there] was a big drop in U.S. consumer spending—far more than can be explained by the stock market crash. The drop may have been a backlash to the rise of installment lending (for cars, furniture, and appliances) in the twenties. The prevailing practice allowed lenders to repossess an item if the borrower missed just one payment. People may have stopped making new purchases to reduce the risk of losing things they already had bought on credit [for fear of losing their jobs]. Whatever happened, the slump soon fed on itself. Weak spending depressed prices, which meant that many farmers, businesses, and nations couldn't repay their debts. Rising bad debts prompted banks to restrict new loans and sell financial assets, usually bonds. Scarce credit led to less borrowing, less spending, lower prices, and more bankruptcies. Trade and investment spiraled downward.
The consumer collapse that began in June 1929 inexorably spread and deepened, month by month by month, throughout the rest of 1929 and 1930, a vicious spiral of ever more layoffs, ever more wage cuts, and ever more price cuts, while accumulated debts became ever more unaffordable.
Let me be clear: although the stock market crash of October 1929 is the event our history books teach us, in fact it was Main Street that consistently lead the downturn. The stock market continued to boom until September 1929, and rallied several more times thereafter, only to be crushed by the spreading and deepening misery on Main Street.
In our Panic, however, while the housing bubble burst first, nevertheless it is the financial sector that is the epicenter, and Main Street is so far only peripherally giving way. Although housing has been faltering since 2006 (just as the 1920s real estate bubble peaked in 1926), other consumer areas have either not fallen or are just now falling to recessionary levels. Retail sales are still nominally positive, services and manufacturing in the real economy are not expanding, but not significantly declining either.
This is not to minimize the ongoing suffering of average Americans. During the last 7+ years of the Bush Administration, the working and middle classes have suffered greatly and never did participate in any of the real gains of the last economic expansion. Americans collectively have been living on credit cards and home equity loans, in other words, on fumes. Poverty now has little correlation to education levels, skills and age. As a result, the middle class looks like swiss cheese, as millions of people ever so gradually have been kicked out. The point is, whatever this suffering has been, it has not dramatically increased for Main Street America beyond gas and food prices in the last year or so, except for those who were caught in the housing bubble.
Look at your own life and those of your family, friends, and acquaintances. In the last 18 months, aside from the surge in gasoline and food prices, have your and their lives dramatically changed? Probably not.
Instead, it is the financiers who have been crushed: first mortgage lenders, then hedge funds, and then investment houses and now giant government sponsored agencies and insurers have all imploded dramatically, causing the value of America's financial sector to be cut in half. In contrast, regular savings and commercial banks, aside from the very few that were heavily involved in "alternate" mortgage products, have been untouched. The "run" is on the unregulated "shadow banking system", not the plain vanilla corner regulated bank. It is as if one half of the body economic is rattling on its deathbed, and the other half is running a mild fever.
The crucial issue now is whether the "Slow Motion Panic" causes Main Street to come down with pneumonia as well. "If Wall Street crashes, does Main Street follow? Not necessarily", says the Financial Times, recalling that the 1987 Wall Street stock crash left the Main Street economy almost completely unscathed. In our own present case, retail sales have declined slightly, and auto sales have crashed. Industrial production, chiefly centered around the auto industry, is also in decline, but not yet at levels equal to or greater than the relatively mild 2001 recession.
But the tools available to the Federal Reserve in 1987 -- cutting rates, getting stronger players to take over weaker brokerages, a vibrant underlying economy -- either don't exist now or have already been virtually exhausted. Moreover, as individuals feel the 25% losses in their retirement portfolios, it is realistic to expect that "fear itself" will finally take hold and consumer purchases will slow significantly. If so, this could begin another round of the vicious spiral as house prices fall further, leading to further writedowns in mortgage related collateral, leading to further financial calamities and further consumer fear.
It is hardly an exaggeration to say that trying to minimize the financial pandemic's infection of America's Main Street economy is the single most critical job that will await the new, hopefully Democratic, Administration and Congress on January 21, 2009. There is a model: the Swedish banking crisis of the early 1990s (the below quoted paragraphs do not do justice. Click on the link to read the entire article):
A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar? It does to Sweden.....But Sweden took a different course than the one now being proposed by the United States Treasury. And Swedish officials say there are lessons from their own nightmare that Washington may be missing.
Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government. That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.
....
A few American commentators have proposed that the United States government extract equity from banks as a price for their rescue. But it does not seem to be under serious consideration yet in the Bush administration or Congress.
....
By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.
Fancy that? A tried and true method, that would inflict pain on Goldman Sachs and Morgan Stanley shareholders is "off the table." Instead, according to this bloomberg financial news article, guess who is likely to gain the most from the Paulson $700 billion bailout? No surprise, it's Goldman Sachs and Morgan Stanley shareholders. The fact that financial houses across the globe are lining up to participate in Paulson's "distress sale" should tell you everything you need to know about the "sacrifice" they are being asked to make.
Instead, as put succinctly by CNBC yesterday:
If you’ve been worried about the health of the economy and you also have doubts about the soundness of the Treasury’s Wall Street rescue plan, then be afraid, be very afraid—because the US economy may get a taste of what Japan’s suffered over a decade-long period.
“The Wall Street mess will now have collateral damage to the real economy,” says Steve Hanke, a former White House economist. “We're coming into this thing in a terrible situation."
We appear to be only days away from a catastrophic long-term decision that will cause untold misery not only to us, but for American generations to come. The herculean $Trillion effort to bail out Wall Street at the expense of taxpayers may well not save it, but it will, finally, kill Main Street as well.
That the names of the Titans of Finance and Politics --both the Republican malefactors and their Democratic enablers -- who refused to listen to the voices of alarm that have been shouted from the rooftops for almost half a decade, and who are squandering the entire wealth of the Nation in a vain and vein effort to rescue Plutocracy, will live on in Infamy, does no good to those who must live through the suffering to come.