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Footprints of a crisis past

By Daniel M. Ryan
web posted November 10, 2008

Currently, the Big Three automakers in the United States are trying to present themselves as Main Street's answer to the banking system. According to the supporters of the impending Big Three bailout, a few million jobs will be lost if GM, Ford and Chrysler go bankrupt. The bankruptcy of those three will set off a chain reaction of bankruptcies, much like a bank failure sets off a chain reaction of bank runs. Just as a general bank run crushes many banks, including solvent ones, a "bankruptcy run" in the auto sector will set off a chain reaction of closures even in otherwise healthy suppliers. And, just like a bank run ruins many innocents' life savings, the auto-sector "bankruptcy run" will ruin many people's jobs and many other people's repair options. There's only one argument where the analogizing overlaps completely: both a bank run and a "bankruptcy run" would ruin the stock market, and risk wrecking many people's retirements – including people who had no exposure to any part of the particular sector at risk.

Whether or not this linkage is credible for the auto sector, the bank-run calamitousness being linked to does have credibility. Or, at least, it used to. In addition to the usual critics that have surfaced as GM's fate is weighed in Washington D.C., there have been a surprisingly large number of street-level critics who think that Wall Street played chicken with the American taxpayer – and that the mandataries of the taxpayer flinched. It's a surprising flip-flop in American political culture, and one worth noting. The linkage put forth by the auto-sector advocates is connected to a rock that might be eroding.

Amongst the critics of the TARP bailout, there seem to be ones that scoff at the very idea that the banking system was in serious danger. Given the realities of moral hazard, it's not shocking to see that kind of cynicism. The Federal Reserve data from the time, though, do suggest that the system was on the verge of a bank run. Evidence of a real mid-September threat can be found.

Credit Crisis Past…

The relevant Fed release in which it can be seen is H.3, the "Aggregate Reserves Of Depository Institutions And The Monetary Base." It's this report shows whether or not the central bank is "pushing on a string."

"Pushing on a string" means far more than excess reserves piling up in the system. In order for a central bank to (at least presumably) face string-pushing, three factors have to be in place:

  1. Total reserves have to be increasing. This increase shows that the central bank is trying to boost the money supply through raising the amount of reserves that the banks can lend on.
  2. Excess reserves have to be piling up. This increase shows that the banks are reluctant to put the added central-bank-supplied reserves into the stream of credit, as granting new credit means creating new deposits.  
  3. The final criterion is the crucial one: required reserves have to be dropping. "Required reserves" are set percentages of deposits mandated by statutory limits: they're the monies that the banks have to keep in the central bank in order to have sufficient funds to meet normal withdrawals, or to meet withdrawals that fall in the bounds of "normal-excessive." If required reserves are dropping, especially during a time when bank troubles are beginning to make the headlines, it's an indicator that the money supply itself is beginning to evaporate.

Of course, a drop in required reserves isn't a definitive sign that the central bank is in fact pushing on a string. Required reserves can drop for a different reason: the public could be shifting deposits from accounts with a greater required-reserve ratio to ones with a lesser ratio – or to accounts with no required reserves at all. In the American banking system, this would mean an en masse shift from demand accounts to savings accounts, whether of old deposits or newly-created ones. Demand deposits require 10% reserves, while savings accounts require no reserves. So, further checking is needed – including for other indicators that the money supply is about to fall.

That requirement to check further, though, is more for academics than action-oriented monetary authorities in stormy times. Seeing names on this list piling up at about the same time as the three criteria are in place, is enough to get a hurried Treasury Secretary and a worried central banker carving together a rescue plan. Those three criteria were met between September 10th and September 24th: this October 30th H.3 release shows it. In mid-to-late September, the entire monetary-supply-generating system did indeed have a close scrape with real money-supply implosion despite the Federal Reserve's own actions. Hence the shift in course, from the new Fed-supplied credit facilities to more direct relief from the Treasury.

…And Past Credit Crises

Doomsayers have certainly had their day recently. The credit-crunching "Black Swan" has indeed shown up, and it has certainly been on a rampage. The observers who saw it coming, such as Nouriel Roubini, have certainly had their earlier warnings vindicated. Warren Buffet has certainly had cause to eat out on his March '03 characterization of mortgage-based derivatives as "financial weapons of mass destruction". There's little grist to argue against the prescience of this kind of Cassandra.

Except for the ones who insist that the current implosion is unprecedented. The fact is, this particular kind of dark swan has shown up before, and will likely do so again.

There are two factors behind each asset-class implosion that has bedeviled the U.S. financial system since (at least) 1970. The first is the credit-quality-degradation cycle, identified by James Grant. Simply put, if put somewhat differently than Mr. Grant's own version in Money Of The Mind, it works like this: when the bust ends, lenders are cautious at first because they all remember the recent bad times. This reticence creates a "cartel of fear," which holds back lending somewhat. Unlike the typical cartel, this "cartel of fear" has as its aim not profit boosting but loss avoidance. The members of said (usually spontaneous) "cartel" all decide to take it extra cautiously because of fear that recent signs of recovery are a fake-out: a Main Street analog to a stock-market sucker rally.

All cartels have "cheaters," and the "cheaters" in this case are the bankers who go back to normal lending practices. They reap extra gains by doing so, and in so doing break the "cartel of fear." They also set up a certain momentum, which is reinforced by the economy moving from recovery to boom.

Since the "Cartel-of-Fear busters" reaped real entrepreneurial profits by lending more freely than their competitors, it seems rational subsequently to keep lending less cautiously as recovery turns into boom. This momentum contributes to even freer lending, and to lending standards that lower as the boom goes on. By the time recent memory contains only prosperity and more prosperity, by the time the need for lender's reticence appears merely "theoretical," by the time the boom climaxes, a lot of shaky loans have been made. They just don't seem shaky at the time because growth seemed eternal.

Once the boom turns into bust, though, a lot of those loans end up going bad…and the seeds of yet another "Cartel of Fear" are planted yet again.

This cycle, although real, primarily affects ordinary lending. When a new asset class is invented, though, the credit-degradation cycle is magnified tremendously by the all-American Boom Town effect.

Imagine a new kind of security that delivers a superior risk-adjusted return, in good times and in bad. Imagine, also, that all the then-conceivable Is have been dotted and the Ts crossed with regard to risk-avoidance. Imagine further that this asset class holds its superiority during the next (or first) real downturn it faces.  

"Ye Gawds! There's real Gold in those hills!"

And, of course, the asset class in question balloons in popularity. If real gold's being found, who would refuse except for people who prefer their settled ways?

Almost inevitably, just like "Bonanza County" in the non-financial economy, said Boom Town gets way overbuilt, and the excited denizens go way overboard. It's only a matter of time before Boom Town will turn into Bust Town. To wit:

  1. Commercial Paper: imploded in 1970.
  2. Sovereign Loans: imploded in 1982.
  3. High-Yield Bonds: imploded in 1989-90.
  4. What were known as "Derivatives" in the 1980s: imploded in stages, 1991-4.
  5. Stochastic Risk Arbitrage: imploded in the late 1990s.
  6. Collateralized [Mortgage] Debt Obligations and Credit Default Swaps: imploded this year.

As a Randian would say, even dark swans have identities. One attribute of these credit-crunching swans – like the attribute of any Boom Town – is that the first bust is the worst bust. ESR

Daniel M. Ryan is a regular columnist for LewRockwell.com, and has an undamaged mail address here.

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