Lesson From a Crisis: When Trust Vanishes, Worry

Lesson From a Crisis: When Trust Vanishes, Worry
David Leonhardt
Sep 30, 2008

http://www.nytimes.com/2008/10/01/business/
economy/01leonhardt.html

For now, the crisis has had little effect on most Americans, beyond their 401(k) statements. So to them, the specter of a depression can sound alarmist, and the $700 billion bill that Congress voted down this week can seem like a bailout for rich scoundrels.

Almost no economist thinks that even a terrible downturn would look like the Depression. The government has already responded more aggressively than it did in Herbert Hoover’s day. So a Depression-like contraction — a 30 percent drop in economic activity — is highly unlikely. The country is also far richer today, which means that a much smaller portion of the population is living on the edge of despair. No matter what happens, you’re not likely to see shantytowns.

But the Depression is still relevant, because the basic mechanics of how the economy might fall into a severe recession look quite similar to those that caused the Depression. In both cases, a credit crisis is at the center of the story.

At the start of the 1930s, despite everything that had happened on Wall Street, the American economy had not yet collapsed. Consumer spending and business investment were down, but not horribly so.

In late 1930, however, a rolling series of bank panics began. Investments made by the banks were going bad — or, in some cases, were rumored to be going bad — and nervous customers besieged bank branches to demand their money back. Hundreds of banks eventually closed.

Once a bank in a given town shut its doors, all the knowledge accumulated by the bank officers there effectively disappeared. Other banks weren’t nearly as willing to lend money to local businesses and residents because the loan officers at those banks didn’t know which borrowers were less reliable than they looked. Credit dried up.

“If a guy has a good investment opportunity and he can’t get the funding, he won’t do it,” Mr. Mishkin, who’s now an economics professor at Columbia, notes. “And that’s when the economy collapses.” Or, as Adam Posen, another economist, puts it, “That’s when the Depression became the Great Depression.” By 1932, consumption and investment had both collapsed, and stocks had fallen more than 80 percent from their peak.

As a young academic economist in the 1980s, Mr. Bernanke largely developed the theory that the loan officers’ lost knowledge was a crucial cause of the Depression. He referred to this lost knowledge as “informational capital.” In plain English, it means that trust vanished from the banking sector.

The same thing is happening now. Financial markets are global, not local, today, so the problem isn’t that the failure of any single bank locks individuals or businesses out of the credit markets. Instead, the nasty surprises of the last 13 months — the sort of turmoil that once would have been unthinkable — have caused an effective breakdown in informational capital. Bankers now look at longtime customers and think of that old refrain from a failed marriage: I feel like I don’t even know you.

Bear Stearns, for example, was supposed to have solid, tangible collateral standing behind some of its debts, so that certain lenders would be paid off no matter what. It didn’t, and they weren’t.

The current, more serious stage of the crisis began two weeks ago today, after the collapse of Lehman Brothers and the Fed’s takeover of the American International Group. Those events created a new level of fear. Banks cut back on making loans and instead poured money into Treasury bills, which paid almost no interest but also came with almost no risk. On the loans they did make, banks demanded higher interest rates. Over the past two weeks, rates have generally continued to rise — and these rates, not the stock market, are really what you should be watching.

The current fears can certainly seem irrational. Most households and businesses are still in fine shape, after all. So why aren’t some banks stepping into the void and taking advantage of the newly high interest rates to earn some profit?

There are two chief reasons. One is fairly basic: bankers are nervous that borrowers who look solid today may not turn out to be so solid. Think back to 1930, when the American economy seemed to be weathering the storm.

The second reason is a bit more complex. Banks own a lot of long-term assets (like your mortgage) and hold a lot of short-term debt (which is cheaper than long-term debt). To pay off this debt, they need to take out short-term loans.

In the current environment, bankers are nervous that other banks might shut them out, out of fear, and stop extending that short-term credit. This, in a nutshell, brought about Monday’s collapse of Wachovia and Glitnir Bank in Iceland. To avoid their fate, other banks are hoarding capital, instead of making seemingly profitable loans. And when capital is hoarded, further bank failures become all the more likely.