Bank panics occurred at the start of the Great Depression of 1929-39 and the current Great Recession which began in 2007. Not all economic downturns experience bank panics. But when they occur, the issue of how the panics are tackled can make a huge difference in the severity of the subsequent economic downturn. Bank panics are systemic events. Even solvent banks that have been prudent in making loans to businesses can face a liquidity problem when all depositors withdraw money at the same time. And when banks fail, business activity falters as credit dries up.


When you think about it, banks are naturally prone to insolvency as they take short term loans and deposits (borrowing short) and make long term loans which cannot be quickly converted into cash (lending long). Borrowing short and lending long is one of those essential tasks that have to be performed in a market economy. One solution for heading off bank panics is to establish a lender of last resort – a reserve financial institution that is willing to extend credit when no one else will. Walter Bagehot (1826 –1877), editor-in-chief of The Economist, was one of the first individuals to recognize the need for such an institution. TheUnited States recognized the need in 1913 when it created the Federal Reserve System to act as a backstop to stave off larger bank runs and panics.


However, between 1930 and 1934 the Fed failed to prevent a systemic crisis in the misguided belief that the banks experiencing bank runs were badly managed and that allowing them to fail would protect the integrity of the banking system. The cycle of bank runs only ended when federal deposit insurance was introduced in 1934, removing an incentive for retail depositors to withdraw their deposits in an economic downturn. Banks were also required to be chartered. Entry into the banking industry became limited and banks acquired local monopoly status in accepting deposits. Interest rate ceilings were maintained on deposits, known as Regulation Q in theUS. (An Interest Rate Agreement on deposits was also maintained by the Hong Kong Association of Banks for Hong Kong from July 1964 to July 2001.) These factors made banking profitable and provided banks with an incentive to self-regulate to protect their valuable charter. As a result, banking in theUSentered a quiet period from 1934, broken only by the savings and loan crisis (S&L) and several bank failures during the business cycle starting in July 1990. There was no systemic crisis until 2007.


Bank Mismanagement and Bank Panics


The idea of mass hysteria causing bank runs is often exaggerated. Most bank runs inUShistory were caused by banks that were actually insolvent as a result of bad decisions and bad loans. For the most part, people are not irrational when they rush to a bank and pull their money out. In principle insolvent institutions should be allowed to go under if market discipline is to be maintained and respected.


When Walter Bagehot proposed a lender of last resort in the 19th century, he did not intend for it to backstop every financial institution that got into trouble. Rather, he was a proponent of the central bank quickly intervening during a bank panic by lending freely and readily, at a penalty rate of interest, to any bank that could offer “good collateral”. Bagehot insisted on an asset-for-cash swap and believed that the central bank must make sure the securities were of high quality.


This means that if a bank is insolvent due to bad decision making and does not have quality assets to exchange for a backstop, Bagehot would not recommend intervening. The difference between insolvent and illiquid is the key. Insolvency means a bank has assets worth less than the money it owes to its depositors and creditors. If a bank is illiquid, it means that its long-run expected future cash flows are still greater than its outflows; but unfortunately for the bank more depositors than usual have showed up for their demand deposits over a short period. An illiquid bank would have no shortage of quality assets in their portfolio, but is just short on liquid assets or those that can easily be converted into cash.


Backstopping insolvent banks creates an increasingly perverse moral hazard dilemma. An efficient marketplace depends upon making people pay the price for acting recklessly, but Bagehot’s advice against throwing good money (ultimately taxpayer money) at bad banks has been mostly ignored. The Fed bailed out Franklin National in 1974, which was insolvent. It bailed out Continental Illinois in 1984, which was insolvent. It coerced a private rescue of Long-Term Capital Management in 1998, which was insolvent. Every time the Fed intervenes, it ups the ante for a potential moral hazard.


Too Big to Fail Versus Bagehot’s Advice


The doctrine of “too big to fail” supposedly justifies ignoring Bagehot’s sound economic advice to only offer liquidity to sound balance sheets. The argument now is that financial firms are so large and so interconnected with each other, that one domino failing would topple the entire system. In other words, every bank run is to be regarded as a systemic event. The shadow banking system of collateralized loans is a perfect example of this perception, which essentially invites us to accept a banking system where profits are privatized and losses are socialized.


The moral hazards that were sowed in the banking system were amplified by the ability of the shadow banking system to leverage up its business on a much larger scale than was previously possible. When theUSeconomy turned down in 2007 as the property markets fell, depositors in the shadow system made a run on the banks. At first large depositors began to worry about the true worth of their portfolio of sub-prime mortgage loans that they were holding as collateral against their deposits. As events unfolded, a full blown panic in the shadow banking system began to set in in August 2007.


When faced with the totality of the crisis, Hank Paulson and Ben Bernanke appealed to Congress for an unprecedented USD700 billions in Troubled Asset Relief Program (TARP) funding to backstop failing financial institutions. It was an astoundingly large amount at the time, the size of which was intended to restore confidence in the markets. The panic abated. The follow up measure to stress test the banks was also intended to restore confidence. To the credit of the rescue team, these confidence restoration measures worked. The threat of a full blown systemic crisis was averted.


TheUSeconomy stopped slipping, but has continued to languish at below trend or near zero growth rates and at unemployment rates stuck around 9% for the past 3 years. Compared with what happened in the Great Depression, it is obvious some valuable lessons have been learned as we are not suffering from a 25% unemployment rate this time.


Nonetheless, the rescue of the banks has ignited deep divisions across large segments ofUSsociety over the ethics ofMain Streetbailing out Wall Street. A banking system that was too big to fail and straddled with moral hazard can be seen as the legacy of the Fed regulatory policy to bail out insolvent banks that began in the 1970s. Moreover, the system’s perverse incentives, which privatize profits but socializes losses, are increasingly suspected of being not just bad policy, but also evidence that the political system has been captured by powerful banking interests. Such sentiments are tied to growing anti-Washington and anti-big government movements that see the current crisis as the culmination of decades of erosion of the core values of prudence and moral responsibility. It is no wonder, then, that Fed Chairman Ben Bernanke has been accused of treason by some politicians for adopting policies that could lead to inflation? The rise of the Tea Party speaks to these sentiments. The “Occupy Wall Street” protest is more difficult to characterize at this point, but one protest banner reveals a telling sentiment: “They Got a Bailout. We Got Sold Out.”


Fiscal Stimulus in Doubt


Looking across the world since the Second World War, there have been hundreds of recessions and dozens more serious crises for individual economies, currencies and sovereign states. The chosen solution of governments and central bankers has been either to spend their way out of these recessions, or to devalue their currency to regain competitiveness and enable growth to revive. This has meant transferring the pain from the private sector — banks or firms or households that had over-borrowed and overspent — to the government through some kind of bail-out mechanism. 


The result of this is that private sector debt has been transferred to the public sector. Over time the ratio of public debt to GDP has increased in almost all economies,Hong Kongfortunately being an exception. In theUS, the combined debt-to-GDP ratio for the private and public sectors together increased modestly from around 140% in the late 1950s to 150% by 1980, but then soared to 375% in 2010. Countries inEuropehave seen similar increases.


Since the credit crisis of 2007 theUSprivate sector has been de-leveraging, but this has been offset by the public sector leveraging up to finance spending on fiscal stimulus. The result is that non-financial sector debt has not declined, but has remained roughly unchanged at 240%. Governments and central bankers in the US, Europe, and Japan have continued to borrow and spend more money in the hope that private sector growth will pick up, GDP will revive, and government tax revenues will recover. And central banks stand ready to create money to finance the spending. This is the Keynesian solution to getting the economy out of a recession.


When President Obama took office in January 2009 he rolled out a two-year fiscal stimulus program of $800 billion to create jobs and jumpstart economic recovery. This was of course a classic Keynesian solution. What was really puzzling to my generation of economists was why the President was counseled that fiscal stimulus would work. Economic research over the past 30 years has cast considerable doubt that there is a fiscal multiplier effect on both theoretical and empirical grounds, not to mention a significant multiplier effect.


Professor Robert Barro ofHarvardUniversityhas shown empirically that for every $1 spent over the long term, the cost to the economy will be more than $1 – creating what he called a negative fiscal multiplier. The only fiscal stimulus effect that could be found historically to be positive was war expenditure during the Second World War.


Theoretically the Keynesian solution has a well-known flaw. It focuses on income and expenditure flows and ignores the underlying deterioration in private and public sector balance sheets. Fiscal stimulus can only work under either one of three situations. The first is if the total debt, private and public combined, is relatively low in relation to income flows so that it can be serviced without overburdening households and firms with unsustainable higher future tax burdens. The second is if the debt can be devalued through either currency depreciation or domestic inflation. The third is if debtors are willing to forgive the debt.


Downgrades of Sovereign Ratings


Total debt levels in theUS, Europe andJapantoday are so large that the first condition cannot be met. Ratings agency Standard & Poor lowered the sovereign credit rating of several major industrial nations this year:JapanandSpainfrom AA to AA- ,Italyfrom A+ to A, and theUSfrom AAA to AA+. Standard & Poor said in a statement in August that “the [US] downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned…..further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.” What is at stake is not just $14 trillions of actual federal debt now, but the long term projected US deficits, including entitlements programs, that add up to amounts in the order of $60 trillions. These ratings downgrades are momentous events. Never before since the dawn of the Industrial Revolution have so many major industrial economies been taken to task for failing to manage their public finances.


Devaluing their currency or inflating prices against the rest of the world would bring insufficient help given the combined size of their economies. Devaluing or inflating against each other would also be futile because it would certainly invite retaliation. And inflating away debt would ignite domestic resistance among populations that have become very sensitive about being sold out again.


Their combined debt is so large that there is no one else left to forgive their debts except themselves!


All of this means that the usual adjustment mechanisms are seizing up and the economic recovery is stalling. Households and firms are reluctant to spend and banks are unwilling to lend until they have repaired their balance sheets. Governments are looking less and less creditworthy as their public debts pile up. The cost of financing public debts looks set to increase as investors demand higher yields for the increased risk of lending to financially weak governments. Economic recovery then becomes even more difficult.


The big difference between this Great Recession and the Great Depression is that governments now are bigger, perform more functions, take on huge responsibilities for entitlements like social security and medical care, and are running huge public debts to meet these obligations over the long term. The current deep recession exposes the vulnerability of this situation. Governments during the Great Depression did not have public debts other than during war time. Keynes’ great innovation therefore was to invent deficit financing. He tried to solve the problem of an economic downturn by borrowing from the future generation. This probably can work when government credibility is robust but not when it is fragile.


Sovereign Creditworthiness Falling in US and Europe


By downgrading sovereign credit rating, Standard & Poor is in effect advising individual and institutional investors not to lend to theUSand other governments on the same terms as before. Excessive government spending – on welfare, health, the environment, transport, the military, policing and justice, regulation and a myriad of other seemingly worthwhile causes — is creating huge fiscal deficits each year. The deficits are adding to government debt, and the debt has now climbed to dangerous levels. This cannot continue. In effect, theUS, European and Japanese governments have exhausted their credibility.


During the Great Depression, theUSgovernment failed to stop a bank panic in the belief that bank runs happened only to badly managed banks. The government also failed to adopt expansionary fiscal policies to stimulate recovery at a time when governments were not burdened with public debts. Since then we have saved banks that were insolvent believing that otherwise it would lead to a bank panic. Meanwhile governments have grown in size and so have their public debts. When the government had the credibility to prevent the Great Depression, it had failed to do so. It is now trying to jumpstart an economy when its credibility has been considerably eroded.


The Keynesian formula has reached the end of the road. Borrowing from the next generation was a trick because they had no say in this decision. We have all abused them. What is next? It is time to turn to a different, more durable solution. Ultimately, people in the affected countries will have to work harder and consume less to pay off their own debt. Hard work entails investing in productivity and training. It also means tax and regulatory reforms that reward work, not penalize it. Reducing consumption will help and it should include among other things accepting a cut in entitlements, especially social security and health care benefits. None of this will happen soon or easily. These changes will be politically difficult to negotiate. But is there another trick?Hong Kongshould count its blessings for we have not abused the next generation and burdened them with huge public debts. At least so far.




Walter Bagehot, Lombard Street: A Description of the Money Market,London: Henry S King and Co., 1873


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