A rare and fragile victory for expertise

NO, that will take a couple more crises. It simply means that we had a lucky sequence of events. To wit . . .

a) some Congressional Democrats were clever enough to insert the equity thing into TARP without anyone else noticing, using procedures such as reading intent into the Congressional Record . . . and b) the continuing plummeting of the stock markets and the continued yelling of academic economists convinced the British Treasury that recapitalizing banks with equity was the only way to go . . . and c) the Brits forced the hand of the Eurozone through close to $1 trillion in intervention from the Bank of England. Which led to d). Henry Paulson realizing the jig was up.

I think the process might have been less fraught with someone else besides Paulson in Treasury. But don't forget, Paulson's the one who forced Jon Corzine out of Goldman Sachs as punishment for doing the right thing with LTCM back in 1998. It's a pity it took another ten years for someone to yell at him, "Get a clue."

Also, the Republicans are still the party of Herbert Hoover -- after all this time. They're STILL bleating about socialism. There was no way Congressional Republicans were ever going to accept what the Dems and the UK Treasury did. They would have gone down with the ship before admitting they were wrong. And for that reason, they're just not fit to govern.

Will someone please offer us a new conservative party? One that is actually empirically based?

I respectfully disagree with DB. I think the country right now is ready to throw it's hand in with whatever works or seems likely to work; The British plan seems the solution du jour. Paulson already announced a plan to recapitalise the banks and I think guaranteeing interbank loans for a period is also a good idea.

We shouldn't get too hung up on where good ideas come from - just use them as we see and understand them.

One thing we haven't seen from US and UK policymakers is too much complacence. But Paulson and Bernacke have been fighting the fires for months, while it took a while for academnic economists to diagnose the problem(s) and come to a concensus about solutions. Don't blame the firefighters for not formulating correct theory while they fight fires. They are using the output of the academic community and that should be enough for everyone...

BTW, it seems that Paul Krugman was awarded the Nobel Prize for Economics this morning.

A Nobel Prize to the economist who was called shrill because he was right about the Bush administration years before it became cool to be right about the Bush administration.

"some Congressional Democrats were clever enough to insert the equity thing into TARP without anyone else noticing..."

I think people noticed it was in the bill--at least I heard about it. The surprise is that Paulson decided to use this authority.

The Democratic victory in the 2006 elections accomplished a lot. I don't think that the approach you see Paulson taking (trying to figure out how to solve the problem rather than sticking to a rigid ideological agenda) would have been possible if Bush hadn't gotten a wakeup call.

Just a thought - are any of these economists we are talking about the same economists that so skillfully managed Russia's graceful entrance into the world of capitalism in the 1990's?

I can only hope that watching investments evaporate can instill a bit of pragmatism in even the most rigid of ideologues.

That said, as our esteemed Prof. Drezner noted, the TED spread is still super high, and is only down by about 1.5%.

Not being an expert on financial collapses, I have no idea what to expect to indicate that people are exhausted / calming down. Is it more likely to see the TED drop rapidly, or will it be a slower decline as our banking sector gets a little less panicky day-by-day (not to mention as people in this sector get used to working in the civil service!!!). Should we see high TED scores for days, weeks, months, even as things get better, or should TED respond more rapidly?

If economists can't even accurately predict their Nobel prizewinner, why should I trust their judgment on less important matters. :-)

This is interesting though--when and how do academics exert influence in world affairs? Seems as if economists may be more influential than other fields, perhaps because the economy is more measurable than other fields.

It's interesting to me that one Bernake himself is an academic who studied... financial disasters.

I hope that what we are seeing is the result of doing a more sober assessment of the situation. The initial bailout bill was all about "do something, now!" It was not presented as one of many options, but as the only option. The bill as written allows for a great deal more flexibility in response; hopefully, as Paulson and treasury began to contemplate how to spend their $700 billion, they decided that getting a great deal of input might be the way to go.

Eric, the most alarming thing to me is the fact that the TED spread was actually kind of a fictional thing for a time - there was little or no interbank lending happening at any level of interest.

A fall in the TED spread could be reassuring however, as it may indicate that interbank lending is finally occuring. Or it could mean that the people who set the TED spread believe that interbank lending will resume, now that European governments seem set to guarantee such lending for a period.

My question about the plan is whether the guarantees extend to international loans - to lending across national boundaries. It almost can't in some cases, such as to Iceland right now.

There was an interesting piece in the London Times today by William Reese-Mogg comparing the current panic with the Panic of 1907. A study of the 1907 panic shows that there were 6 stages:

(1) Failure of an important bank or institution: the Knickerbocker Trust in 1907;
(2) Heavy withdrawals of funds by depositors;
(3) Demoralised stock markets affecting banks and depositors alike;
(4) Hoarding of money in large amounts, not only by individuals, but by banks;
(5) Gradual improvement in financial affairs;
(6) Acute trade reaction, discharge of thousands of employees, and realisation that the country must pass through a more or less severe industrial reconstruction.

We seem to be in stage 4, or possibly coming out of that stage because if the TED spread shrank that may indicate resumption of interbank lending.

http://www.timesonline.co.uk/tol/comment/columnists/william_rees_mogg/article4931200.ece

I have wiki'ed pages of various US Panics, the Panics of 1857, 1873, 1893, 1907, and of course 1929.

The 1907 panic seems to be the closest match to what we are seeing now in that it is a banking panic and a liquidity crisis. JP Morgan 'fixed' that panic by allowing some insolvent banks to go bust but bailing out in turn:

1) Solvent but illiquid banks.
2) The NYSE, or rather by providing liquidity to keep trading on the NYSE going over two dangerous days.
3) New York City from another liquidity crisis which was bankrupting the city.
4) Finally arranging the bailout of a major broker who was long in shares of one particularly hard-hit Coal, Iron, and Railroad company by arranging the buyout of the coal company by deep-pocketed US Steel.

The US treasury was in it up to the eyebrows, and Teddy Roosevelt had to personally sign off on the suspension of anti trust laws to allow the US Steel buyout.

It sounds very familiar somehow.....

http://en.wikipedia.org/wiki/Panic_of_1907

The Panic of 1907 seems to have had a similar cause to the Panic of 2008, though this one is global, not limited to the US.

The market peaked in January 1906 and fell perhaps 13-15% over the remainder of 1906, then fell another 25% over the first 9 months of 1907. There were a number of events, notably a collapse in the price of copper. This caused bearish speculators to short the shares of the United Copper Company.

On October 14th, with the share price of United Copper at $39, some of the major owners of United Copper decided to launch a Bear Trap - that is to buy up the remaining shares of the company on the open market and 'trap' the bears shorting the company ino having to buy out of their positions at prices set by the owners.

The bear tap failed - disasterously. The price rose from $39 to $52 but the bears found enough sellers and were able to get out. The owners were forced to sell United Copper at disastrous prices as the price fell to $10 by October 17th. But a group of banks associated with the now bankrupt owners had leant money on these shares - presumably at $39 or higher, so these immediately became the equivalent of today's subprime mortgages. Bank runs followed and banks also went bankrupt. That led to to a run on the Knickerbocker Bank October 22nd, and when the Knickerbocker Bank failed the rout was on.

I think all this really tells us is that sellers were exhausted by Friday afternoon. We still don't know what impact all this is going to have on the real economy. The market could very well test last week's lows once we get that information.

On the other hand, it's obviously positive that Europe has decided to follow our lead rather than fight us on economic policy, as it has been doing for the past year.

And, at least for one day, I'm not afraid to look at my brokerage statement.

Rob, Europe seems to be following the lead of Gordon Brown and the UK government as much as anything. There still is no trans-european mechanism in place, but the big european countries have agreed to recapitalise their own banks. As has the US now.

This should be enough to see the liquidity crisis turn the corner, I think.

There may be more crisises up ahead, but if the central banks try to keep ahead of the crisis curve we ought to be OK.

What I'm most concerned about right now are some of the corners of the global economy. Countries like Iceland,
Ireland, potentially Luxembourg, and possibly even
Belgium, Nederlands, Italy, and Austria. What these
countries have in common is that their banking sectors are potentially very large compared to the size of their economy.

The US has had a huge advantage in bailing out our banks because US banks are small compared to the size of the
US economy. I read somewhere that the largest US bank
(JP Morgan) holds liabilities less than 7% of the US
GDP. In contrast, the largest German Bank (Deutsche Bank) has liabilities several times the size of the German GDP. I doubt D-Bank is going to default, but if it ran into a crisis the German government might have a hellacious time saving it by it's own efforts. This disparity largely explains German conservtism about bailing out other European banks, I think

The US advantage is that the banking system is relatively small compared to the size of the real economy, and the shortfalls almost tiny compared to the worth of the total US economy. Lots of miners, factory workers, software engineers, and farmers compared to the number of bankers. That isn't as true over much of Europe.

Iceland is completely swamped by it's banking problem, with bank liabilities many times the Icelandic GDP. Ireland is only somewhat better off - they have many large banks for a small country. Big banks + small economies = big problem. And there is no mechanism set up to help these countries as yet; that will have to wait for the end of the panic in the big economies. I am unsure about the other small countries situations.

Then there is Russia, which seems to be falling into a financial black hole. The Russian stock market has shut down several times and is down 65% nd counting, with awful management by the Russian government. Nobody knows the solvency of Russian companies or banks, although the Russian government may have a large pot of money from oil sales. But oil prices are down big time.

so my sense is that the crisis is mostly over but may offer some twists in the tale yet.

Don, if you look at it simply from a common sense view, that the basic reason for this crisis is that ordinary people aren't able to make mortgage/credit payments, I don't see what you're seeing. (Sure, maybe now the taxpayer is on the hook for this rather than the banks, but at a certain point there will be negative consequences from these bad debts). And one of the contributing factors as to why this has been as bad as it's been is the Europeans have been fighting us on interest-rate policy for so long, not seeming to understand that it was the dollar's weakness, caused in large part because of the discrepancy on our interest-rate policy, that was fueling the price increases, notably in oil but also in other commodites, which, in turn, was playing a large role in why people could no longer make their payments. They seemed enamored with the rising euro and the bogus theory of decoupling, that somehow this time things would be different. In fact, as soon as a couple weeks back European leaders, including Brown, were saying this was just an American problem (apparently not realizing that their banks were even more over-leveraged than ours). Well, I guess a few bank failures tends to focus the mind. It's a big shift to go from that stance to cutting rates in lockstep with the US after fighting us on this for so long and (like us) putting billions at stake in their banking system in a matter of days. If they want to think they're following Brown on this, then that's fine.

I just don't see how the markets returning to the levels they were trading at Wed./Thurs. of last week can be strong evidence that we're over this crisis, without other significant data to back this up.

Ahem, Rob, There are two crisises. Or rather one problem and a crisis.

The problem is as you pointed out, that we are in the middle of a consumer-spending recession which began in Q2 with the commodity spike. But it's going to continue to be driven by falling house prices although that fall will affect some regions more than others. It may be aggrevated by the loss of liquidity caused by the banking crisis.

When I wrote that the 'crisis is almost over' I specifically meant the banking crisis. We still have the remander of the recession to deal with, and it may be a prolonged one.

I just read a forecast which predicted unemployment will peak at 8.5% next year (it's currently 6.1% in the US). That would be the worst in almost 30 years. 1980/82 was no fun at all - but it wasn't the Great Depression.

So that was my point - that the banking system is going to heal and we're not going to get a historical depression like the 30's.

Why can't people make their house payment? Because housing prices nationwide are about 130% of the long term trend (30% overpriced). And that is not an even distribution nationally - there are some areas which have already fallen by half. These areas tend to be a very long commute away from most good jobs. This is partially because of the high price of oil but also because these areas have been recently built up and sold to people looking for low-priced houses. That is, the people closest to the financial edge, the ones who probably should not be buying because their incomes are simply too low to support the payments after the baloon clause hits.

But we're not all the way through that problem. One batch of refinancings hit recently, another is coming up at year's end I think.

I understand your argument, Don, I just don't find it persuasive. If all you're arguing is that we've avoided a 30s-style Depression, I'll go as far as saying the deep global recession is likely to avoid a 30s-style Depression. There are too many variables that are unknown at this point to draw further conclusions, in my view (the thrust of my original post), and a one-day stock market rally that rises to the level of what the market was trading at a few days ago is hardly convincing evidence (anyone who has traded the markets for any decent length of time will tell you that bear markets are marked by short sharp rallies as sellers get exhausted, shorts cover, and a new batch of sucker buyers gets drawn in).

We are likely going to be running a deficit of 10% of GDP, and that has to have some consequences; Britain has its own problem with debt and the black hole that is its state sector pension funds (one reason why they were so eager to do business with Iceland) with benefits that are simply now unaffordable (and their own housing bust in just beginning); and, of course, the big holders of all this bad debt are Europeans. And obviously, the spending spree that fueled the global economy on easy credit is now over.

One obvious consequence of having a few state-directed banks (and there will necessarily be consolidation in many other industries) is that they are inherently corrupt and inefficient. Maybe that's an improvement, maybe there was simply no other way because of the magnitude of the problem, I don't know, but to me that kind of healing is like someone saying someone healed from a heart attack because they died.

You seem to want to see some sort of artificial division, where, in my view, none exists. The inflation brought about by poor and uncoordinated interest-rate policy was simply, as I stated, one of the contributing factors to this crisis. You could call it the straw that broke the camel's back or something similar. Obviously, this started well before the dollar collapsed and inflation rose. Again, one of the few positive things I think one can say about this crisis is that now the Europeans seem to have been convinced that their policy of going it alone was misguided, and to follow our lead, and I would expect several more coordinated interest-rate reductions in the near future.

I also would take any forecasts with a large grain of salt due to so many uncertainties; just as an example, we have no idea what 4-5% growth in China will be like, and the amount of social upheaval worldwide this recession will cause.

Rob, I see it otherwise. What you see as a crisis (continuing fall of the stock markets and housing prices in some places) I see as recovery to some level of sanity and a long-term opportunity.

I think it's fairly likely the stock market(s) haven't found their lows yet in this cycle because there are too many outstanding problems which have to recover. I mentioned Iceland and Russia, but one could add the remaining overhanging subprime and short-term mortgage debt to that list. Banks will be liquidated in a more or less orderly manner, people are obviously going to lose their jobs.

Rob, I think we have different personal definitions of 'crisis'. To understand what I define as a crisis you should understand that I am a software engineer who works in a field which has been in a recession since 2001. I have survived - a mere recession doesn't scare me that much. I have very little debt; no mortgage, no car payment, no credit card debt. I live on much less than I did a decade ago, and when I'm working I usually save quite a bit. I have to - there is very little security in my employment. I work a lot in telecoms - do you remember how many telcos have gone bankrupt or next thing to since 2001? A lot - so I don't assume my employer is stable.

When you are living on recession wages while the rest of the economy seems to be throwing a big party it is depressing. I saw my goal of owning a house someday recede over the horizon while mediocre bankers pulled down 7-figure bonuses every year.

Recession I can live with. Pull the belt a little tighter, maybe cut my net savings a little (but still save). I might have to move or sleep elsewhere during the week - nothing I haven't done before.

What scared me was the prospect of a great depression and what that means for labor markets generally. There have been days during this crisis when I thought it was 75% likely, which is enough to drive a man to the scotch bottle so he can sleep nights.

So what do I see in the mid to long term? Big changes coming. The party is over. I might be on short commons for a while yet, but in the longer term the money will come back somewhere, and this time I rather doubt it will be for huge bonuses for the bankers and upper management classes. Or at least as much, which will leave more for other people.

Housing? I live in London which is still a housing bubble. If that bubble deflates I might actually be able to save up and buy one someday - albeit with a large down payment. If prices fall 40-50% I could afford one, and they might fall that much, some have already.

So from my POV I see a bad 12-18 months which I can live through, followed possibly by marked improvement in my long-term prospects. For me the 'crisis' was the prospect of a Great Depression, which might have made me destitute.