Wednesday, October 22, 2008

The Panic of 2008

We are very pleased to have permission to post the following article which was recently written by George Athanassakos. This article first appeared in the Globe and Mail on October 21st, 2008, p B18. The article also appeared in Globe Investor Magazine.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

There is a lot of talk these days about an upcoming great depression, similar in magnitude or even more serious than the one the world experienced in 1929. While this cannot totally be ruled out, in my opinion, the current economic and financial malaise will be classified by historians as a panic similar to the Panic of 1907 and not the Great Depression of 1929.

The great depression also started as a panic. Following the boom psychology and speculative euphoria of the 1920s, the great depression begun with a catastrophic collapse of the stock-market on the New York Stock Exchange (NYSE) in October 1929, which by June 1, 1932 had wiped out 83.4% of the value of the NYSE. This precipitous decline in the value of stock prices, as well as that of other assets, such as real estate and bonds greatly strained the liquidity of banks and other financial institutions.

Banks sought cash by desperately selling their bonds and stocks in the market driving prices down even further. There was a liquidity crisis. Many banks were consequently forced into bankruptcy. By 1933, 11,000 of the United States' 25,000 banks had failed. This, combined with a general loss of confidence in the economy and government, led to significantly reduced levels of spending, demand and production, throwing 25 to 30 per cent of the work force out of work. There was panic. What made the panic turn into a depression was a number of errors made by policy makers and the central banks.

At the time, authorities showed a great reluctance to intervene to help the economy and the markets. The then U.S. treasury secretary, Andre Mellon, did nothing. President Herbert Hoover decided to let the economy run its course as he was a strong believer in balanced budgets. And the Fed - where was the U.S. Federal Reserve?

With the economy in a deep recession, the Reserve Bank of New York raised interest rates. The Fed’s errors made things worse. Countries the world over sought to protect their domestic production by imposing tariffs, raising existing ones, and setting quotas on foreign imports. This greatly reduced the volume of international trade so that by 1932, the total value of world trade had fallen by more than half.

So what was panic, turned into the great depression.

Is the scenario repeating itself this time around? We definitely have a panic situation. What will prevent it from becoming another great depression is that around the world governments and central banks have realized the severity of the panic and are taking co-ordinated action.

Governments have taken steps to guarantee deposits and prevent a run on the banks. Balanced budget mentality is not taking hold of government actions. Governments have taken control of the situation by being willing to inject capital into the banking system and guarantee banks' loans. Co-ordinated interest rate reductions have been endorsed and carried out by central banks around the globe. Free trade is advocated as a win-win situation around the globe, despite some threats to such trade on the horizon. Financial institutions are not left to fend for themselves and have not been allowed to go bankrupt.

So this panic will not be left to become a depression, exactly in the same way that the panic of 1907 did not turn out to become a depression. At that time, the Dow had doubled between 1904 and 1906. Speculation was running rampant. A “mining stock craze” ensued. Runs began on banks involved in mining speculation. Hoarding of money was widespread, as a lot of money was removed from the system during the panic.

The March 1907 panic wiped out $2 billion (U.S.) from the stock market. The panic was curbed by the intervention of the secretary of the treasury, who deposited large amounts of funds in banks across the United States, but even that did not solve the problems. Municipalities and companies could not place loans and/or underwrite bond issues.

The Egyptian and Tokyo stock markets crashed, and the French market had difficulties. The catalyst that prevented the panic from becoming a depression was co-ordinated actions taken by U.S. officials, but mainly by one man – J.P. Morgan. J.P. Morgan called together a group of more than 50 bankers to his home on Fifth Avenue and locked them into the building until they were willing to provide funds to stop the panic. After some arm twisting, they agreed.

J.P. Morgan also contributed in other ways to add liquidity in the system either on his own or with the help of others. Eventually good banks were supported and saved and others were allowed to fail. The stock market increased by more than 45% in 1908.

The United States and the world were as stunned by the suddenness and magnitude of the Panic of 1907 as they are today. But as long as co-ordinated action is taken to save banks and add liquidity to the system and that is supported around the world, the Panic of 2008 will remain just that, panic, as it was in 1907 and this won’t turn into a great depression as in 1929.

George Athanassakos


Anonymous said...

Great perspective

This mirrors something similar hat a professor of mine (and mentor) from WLU wrote earlier this year on my site about Bernanke's education on the depression and what useful insights we can gain from putting this current crisis into the proper perspective today.
(hopefully its ok to link this post)

Anonymous said...

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mp said...

But the big question is just as in 1907, What have we learned from this? They didn't learn much in 1907 obviously and it took major reform in the 30s. We've effectively wiped out all that reform and the banks are bigger than ever now. To say this is the panic of 2008 like 1907 means that we will see something on the scale of 1929 or worse in coming decades if nothing is done soon about the consolidation in banks and leverage.

Adam said...

The Panic of 2008 involves the socialization of American finance. This is occurring now via the Emergency Economic Stabilization Act of 2008. Secretary Paulson has already made 9 major banks sign on the dotted line. The Federal Reserve is emerging from this episode in weakened condition as an appendage of the Treasury.


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