Panic:
First Wall Street, Then Main Street by Gary North - April
8, 2009
We
have not yet seen panic on Main Street. The malls' parking
lots are full. Most yuppie restaurant chains are still in
business. Their local restaurants may not be as full as they
were a year ago, but they are open for business. There are
still shoppers at Wal-Mart.
Unemployment is now increasing by leaps and
bounds. It rose from 7.1% in December 2008 to 7.2% in January
– not too bad. Then came February: 8.1%. Then March: 8.5%.
In one year, according to the April 3 press release of the
Bureau of Labor Statistics, 5.3 million people became unemployed.
This was an increase of 3.4 percentage points. Most of this
increase has been in the past four months.
Americans are uneasy. Those with pensions
have seen significant declines in their holdings. The net
worth of the median household declined by 23% in 2008 – an
unprecedented fall in the post-War era.
We have not yet seen panic. I think we will
before the end of 2009. If not in 2009, then in 2010.
By panic, I mean a sharp shift in people's
spending habits. I mean half-empty parking lots at the mall.
I mean a decline of at least 50% from today's income at yuppie
restaurants. People will finally start saving again, if they
can. Credit card defaults will double. Already, the figure
is over 4%.
On April 1, Moody's downgraded U.S. corporate
debt by $1.76 trillion. Moody's said this was the largest
single downgrade ever. This signals the worst level of defaults
since World War II. Moody's chief economist, John Lenski,
put it this way: "Business sales and profits fell off
the table in general in the final quarter of last year and
have continued to deteriorate in the first quarter in 2009."
There are those in the financial forecasting
industry who say that the recession will end late this year.
None of these people forecast the recession that began in
December 2007, nor did they predict the collapse of stocks.
They say there is light at the end of the tunnel.
PANIC ON WALL STREET
On April 6, Federal Reserve Board member
Kevin Warsh gave one of the most forthright speeches I have
read from any FED Board member, ever. He was almost breathtaking
in what he admitted in front of a group of high-level international
investors. He titled his speech, "The Panic of 2008."
This panic arrived 101 years after the famous
Panic of 1907, also known as the bankers' panic. It was in
the aftermath of that panic that the Rockefeller and Morgan
banking interests decided to call a truce in order to lobby
for the creation of a central bank.
He began with a litany of problems – problems
of recession.
Deterioration in employment conditions.
Pullback in consumer spending. Decline of industrial production.
Retreat in capacity utilization. Falling capital expenditures.
These measures are objective, all-too-familiar indicators
of recessions.
His speech contrasted recessions with panics.
Recessions are common. Panics are not.
Fear. Breakdown in confidence. Market capitulation.
Financial turmoil. These words are different, not just in
degree but also in kind. They are more normative, but no
less consequential to the real economy. They are indicative
of panic conditions. In panics, once firmly held truths
are no longer relied upon. Articles of faith are upended.
And the very foundations of economies and markets are called
into question.
He believes that the panic of 2008 called
the entire banking system into question, and perhaps more
important, called into question the reliability of contracts.
He has in mind contracts between financial institutions and
the U.S. government. Above all, the near bankruptcy of Fannie
Mae and Freddie Mac and the bailout of October called the
financial structure into question.
He said that the beliefs of economists have
been challenged.
Some economists, market participants, and
historians – not so long ago – were prepared to relegate
these highly charged descriptions of despair to the dustbin
of history. Government policies improved, understanding
of economics deepened, and markets found a more sustainable
equilibrium, or so it was thought.
This optimism was premature, he thinks. We
have now seen events that have called this facile optimism
into question.
The encouraging news, I should note, is
that panics end. And this panic is showing meaningful signs
of abating.
MAIN STREET
The problem with this optimism is that he
confines his discussion of panic to Wall Street. It was panic
among the financial insiders. He does not even mention the
panic of the common American. He therefore ignores the next
phase if the panic, when it moves from Wall Street to Main
Street.
The enormous losses sustained by the financial
markets have made their way into the budgets of Americans,
but not on the order of magnitude experienced by Wall Street.
The common American was not leveraged 30 to 1 in 2007. He
was not subject to margin calls, just so long as he maintained
his monthly payments. This was not true of Bear Stearns and
its clones in the hedge fund world. The average man has no
pension. He has only his job, and he has not lost it yet.
Warsh describes events of 1907. They parallel
events in 2008. There was one overwhelming difference: bank
runs. In 1907, bank depositors withdrew currency and did not
re-deposit it. That reversed the fractional reserve process.
Bank capital imploded. This did not happen in 2008, nor can
it. Depositors transfer deposits to different banks. The total
deposit base does not decline for the system.
The bank runs of 2008 were executed by banks.
They have stashed money – excess reserves – with the FED.
The bankers have pulled the plug on the fractional reserve
process. They have not lent out all the money that the FED's
increase in its monetary base would allow. Warsh does not
mention the problem of excess reserves.
The current financial and economic turmoil
is marked by indicia of both recession and panic conditions.
I don't use words like "indicia."
I prefer "indicators." But however one denotes them,
the indicators are bad. He compared the recession with the
recession of 1981–82. This is common these days. But it neglected
two fundamental differences:
1. Unemployment went above 11% in 1982.
2. The savings rate went to 10%.
Neither of these events has taken place so
far. So, the recession has a way to go before it reaches the
level of despair and panic that we had in 1982. Be patient.
It will get there.
Economic output, as measured by gross domestic
product, contracted at a rate of about 6-1/4 percent in
the fourth quarter of 2008 and is on track to contract sharply
again in the first quarter, which would put the current
contraction among the most severe post-World War II recessions.
He thinks this decline is abating. This assumes
that the panic we saw in 2008 on Wall Street does not play
itself out on Main Street to the same degree. If it does,
the economy will go off a cliff.
What about economic recovery? Warsh is not
optimistic.
The panic conditions that have marked this
period may also have long-run implications. I suspect that
the process of an efficient reallocation of capital and
labor will prove slower and more difficult than is typical
after recessions. Policymakers should be wary of policies
that make the economy still less capable of the growth,
productivity, and employment trends that have marked the
postwar period.
Yet this is exactly what policymakers have
done so far. They have lurched from one expensive bailout
to another. The public is beginning to perceive that the bailouts
are for the banks, not the voters. This has been the case
so far. Warsh does not mention this, but his speech indicates
that he understands it.
Greater clarity as to policymakers' objectives
for financial intermediation would likely prove very constructive
to financial markets. More consequentially, in my view,
it would improve the prospects for economic performance.
Clarity? How can they be clear? That would
be political suicide. Their policies have had a sole objective:
to preserve the largest banks and financial institutions on
Wall Street. So far, their policies have just barely kept
the doors open.
Meanwhile, Main Street is suffering losses
– not so bad as Wall Street's losses, but bad.
In the household sector, Federal Reserve
data indicate that household net worth fell $11 trillion
in 2008, or about 18 percent, the largest annual decline
recorded. . . . For the median household, net worth is estimated
to have decreased at a greater rate – 23 percent in 2008.
Household balance sheets may have contracted about another
7 percent in the first quarter, and I am watching keenly
for that trend to change in subsequent quarters as part
of the recovery.
LOST FAITH
He understands that the general public is
losing faith in the system. Those of us who are Austrian School
economists think there is far more faith remaining than the
system deserves. But Warsh senses that the masses are getting
restless.
As a result, households are questioning
the route to financial security. Homeownership is no longer
perceived to ensure low-risk capital appreciation. And assurances
by investment managers to invest in "stocks for the
long haul" are being subjected to intense scrutiny.
Investors of all stripes – sovereign wealth funds, large
long-only institutional investors, private equity sponsors,
hedge funds, and retail investors – are searching for new
rules of asset allocation and appropriate risk premiums
in an uncertain and unusual economic environment.
In short, investors' confidence in the system
and its present rules has suffered a major setback.
Previously, I argued that we were witnessing
a fundamental reassessment of the value of every asset everywhere
in the world. This diagnosis seems truer, and still more
troubling, today.
He thinks that participants at the highest
levels have lost confidence.
Market participants wonder whether the
forms of financial intermediation and functions of financial
institutions – long connecting savers with investors – will
be implemented in a manner that will enhance, or reduce,
economic well-being. Some are questioning the efficacy of
the remaining vestiges of the existing financial architecture
and remain uncertain of the timing, efficacy, and policy
preferences for the financial architecture that will ultimately
emerge. Surely, they applaud the goal of policymakers to
reform the financial system to make it more durable through
the cycle and less susceptible to shocks. But some query
whether policy actions are, on balance, lessening or stoking
panic conditions.
I have already offered my assessment. Between
early September and late October, the United States economy
moved to fascism. The government-business partnership ratcheted
up so far that the older Keynesian model was abandoned.
THE RULE OF LAW
At stake is the rule of law. He sees this.
Headlines have been dominated in recent
weeks by the legal rules that govern contracts. To be sure,
markets function best when economic actors comport themselves
in a manner consistent with the rule of law. Fidelity to
the rule of law is not just some aphorism for a judicial
system to protect property right disputes among private
parties. Nor should it be just some preachy truism of economic
development for emerging economies. Rather, it is the linchpin
of modern market economies like ours. And it suffers its
greatest blow when the governing authorities are unwilling
to uphold their end of the bargain.
As a good bureaucrat on the Federal government's
payroll – a FED Board member – he affirms his confidence:
Nonetheless, despite some highly publicized
suggestions to the contrary, I remain highly confident that
the government will work tirelessly to uphold its obligations.
Then he added: "Hewing to the rule of
law, however, may be the easier part." Why? Because more
is involved here than government rules. The fabric of trust
has been shred. What is this fabric? He called them articles
of faith.
The panic bred by the loss of confidence
in the underlying financial architecture is difficult to
remedy beyond the purview of statutes and regulations. A
weighty accumulation of unwritten, but no less critical,
practices and understandings governs behavior and establishes
expectations in market economies. Over time, these informal
understandings attract deep and loyal followings by economic
actors. They become articles of faith.
I could not have put it any better. He went
to the heart of the matter in the change that took place between
September and October of 2008. The old faith has been undermined
at the highest levels.
Panics can thus be understood as periods
in which key articles of faith are cast in doubt. How does
this happen? After long periods of economic prosperity –
in the most recent case, the so-called Great Moderation
– articles of faith accumulate.
The boom fosters faith in the system. He
recognizes that what took place in 2008 was not some typical
recession. Something far more fundamental has changed.
Some of these articles of faith are rooted
in government policies; others develop as a matter of private
practice. Regardless of their cause and contour, when faith
is undermined, the resulting fear and ambiguity can accelerate
the deterioration in economic performance.
What happened last year? The senior financial
institutions performed so poorly that faith has been undermined.
Some key articles of faith have been undermined
with respect to some financial institutions. And that is
as it should be. Risk-management failures at some large,
systemically significant financial institutions are now
legendary. In some cases, investors and counterparties came
to rely to their detriment on these entities and their financial
wherewithal.
All true. The question is this: "How
do these institutions get back what they squandered?"
Here, he gets vague.
Market participants appear equally uncertain
about the nature, objective, and duration of the relationship
between the government and financial institutions.
He sees the bailout of Fannie and Freddie
as the archetypes of confusion.
These efforts, while necessary and well
intended, have not completely resolved the uncertainty around
the GSEs to market participants. Indeed, even after extraordinary
actions most recently by the Federal Reserve to improve
liquidity and market functioning in the agency debt markets,
confidence in the GSEs is less than markets were long accustomed
to before this period began.
CONCLUSION
His conclusion points to a restructuring
of the present financial system.
To accelerate the formation of a new financial
architecture, the official sector should outline and defend
a positive vision for financial firms and welcome private
capital's return. The nature and terms of the relationship
between financial firms and the official sector should not
be left in limbo.
He has sounded a warning: the decision-makers
at the top are preparing to re-structure the financial system.
I have said that the deal was done last fall. What is not
yet clear to anyone, at any level, is how this re-structuring
will work. We are in uncharted waters.
Financial stability demands policy stability.
The official sector's policy preferences must be communicated
clearly, credibly, and consistently and backed by concrete
action.
The Federal Reserve was a deliberate mystery
from 1913 until today. The heart of the monetary system is
concealment.
Finally, and perhaps most important, policymakers
across the government must be ever mindful of the long-term
consequences of their actions.
Here is my conclusion, as John Wayne said
in The Searchers: "That'll be the day."