For the first time since 1907, a credit crisis has tipped the US into a recession rather than the other way round. A restoration of some confidence in the credit markets is the only way out
by Ruchir Sharma – ET
History only repeats itself for those who don’t know the details. This old saw is worth keeping in mind amid the rush to compare the current financial crisis with the Great Depression. There is no doubt that the present credit market in credit is the worst since the 1930s, with investment grade spreads widening to levels last seen in 1933. But beyond this segment of the marketplace, all other comparisons with that dark economic age are way off the mark. The stock market cratered by 50% in the first 10 weeks of the downturn beginning October 1929 while industrial production fell by a staggering 9% in the fourth quarter of that year. A massive economic contraction ensued, resulting in a 25% unemployment rate. The magnitude of the current US economic slowdown and stock market drop so far is obviously nothing close to such a cataclysm. The US today is suffering from a classic 19th century style banking panic but the problem is most history books don’t look further back than the 1920s. America, in fact, experienced 13 banking panics between 1814 and 1914. Many of these frenzies had severe global implications; the biggest of those crises was the panic of 1907. The current troubles bear a remarkably close resemblance to that episode and it also the first time since then that a credit crisis has unravelled the economic structure.
Years of blockbuster economic growth and a rapid expansion in credit preceded the panic of 1907. Debt of both the private sector and the government grew significantly, and as stock markets boomed all over the world speculators added to the debt binge by taking out loans to buy securities. Back then the emergence of trust companies was considered a financial innovation. They were similar to modern day investment banks and mortgage companies; these firms operated as commercial banks but were not regulated, didn’t have to hold material reserves and invested heavily in financial markets with capital gains fever running high.
Strains in the system started to appear in 1906 when high quality American railroads found it increasingly difficult to float new long-term paper in Europe, which had theretofore been a large source of capital flows into the US. Liquidity became increasingly tight through 1907 as a series of shocks occurred during the spring and summer of that year. By mid-October there was outright panic after New York’s third largest trust, the Knickerbocker Trust Company, was allowed to go bust. Depositors at other trusts started to flee and a number of banks in New York retracted loans. No one wanted to lend to each other due to counterparty risk. Not unlike today, the panic then spread from Europe to Japan.
In the absence of a central bank, aggressive intervention of the preeminent banker of that time, J Pierpont Morgan, helped rescue the system. Morgan galvanised the New York financial community into action, chartering emergency audit teams to assess the soundness of threatened institutions and organising pools of capital to meet the demands of frightened depositors and brokers. He reached out to the media, religious leaders and politicians. Morgan convinced other bankers to provide a backstop for troubled institutions and used his capital to buy bonds of cities such as New York. Soon it was evident that every financial holding that Morgan backed survived. The panic gradually subsided and credit started to expand again by the end of November 1907.
The characters have changed in the panic of 2008 with the Federal Reserve and the US treasury playing the stabilising role in a crisis that has particularly afflicted investment banks and insurance companies. But in many ways the situation is quite similar to a century ago. US depository institutions presently hold record cash balances with the Fed, suggesting there is plenty of liquidity in the banking system except that institutions don’t want to lend to one another.
Indeed, all credit crises have the same origins. They are rooted in buoyant economic growth that promotes over-optimism, excessive risk taking and extreme demands on liquidity. A subsequent shock of some kind cracks the financial system causing panic among over-extended investors and depositors. A mustering up of liquidity and steps to create greater transparency of bad assets eventually restores the calm. Even though it runs against the spirit of capitalism, government or some outside intervention is almost always required to resolve credit crises as financial panics are all about a loss of confidence. As there is no other underlying asset, there is little that remains of a financial institution once confidence disappears and contagion can spread easily.
The present situation is more like 1907 than other economic downturns as the tail is wagging the dog. In typical credit bear markets, spreads widen due to economic weakness and peak in the latter part of a recession. This time around, the credit crisis occurred before the US even entered a recession and now the credit crunch is likely to push the economy into negative growth territory. In 1907 too, economic output started to contract from May following nearly a year of credit shortages.
Interestingly, the stock market began to recover from November 1907 onwards once credit conditions began to improve but well before the end date of the recession in June 1908. The market usually tends to bottom out only 3-4 months before the end of a recession but since the credit contraction caused valuations to compress in this case, a restoration of lending facilities allowed for market multiples to expand well in advance of an upturn in the economy or earnings.
The other important takeaway from such banking panics is that there is usually a general backlash against Wall Street. The public reaction towards financial leaders in 1907 was largely negative, fuelled by a muckraking press who dubbed it as a ‘rich man’s panic’. It is easy to find scapegoats at the end of a boom, from the ‘evil bankers’ in the 1920s to the ‘mutual fund hawkers’ in the 1970s. Yet, the truth is that a major market slump and a credit crunch are inevitable consequences of a long expansion cycle. Towards the more mature stages of a boom, all sense of proportion regarding risk is lost because of the previous successes.
It is also a natural temptation to draw parallels with the dire events in history during any bear market as fear is often at extreme levels. Following the 1987 stock market crash, many financial observers pointed to the risk of a deep recession. They recalled the experience of 1929, the previous time the market dropped in a similar fashion. Instead, the US expansion rolled on and the economy grew by 4.1% in 1988.
Of course, the current financial crisis is likely to have much greater economic consequences than the 1987 stock market crash as the forces of deleveraging have been truly unleashed. But with the fear of a 1930s redux writ so large, such an outcome will likely be avoided. For one, the policy response is already much different: in the early 1930s authorities allowed the contraction to run its course taking the view that the unprofitable portions of the economy should be ‘liquidated’. In the present context, policymakers have rarely played as activist a role as now.
More importantly, the US does not currently suffer from widespread excesses in the real economy that typically mark a deflationary spiral. Capital spending is broadly in check and inventories levels are low. What’s forgotten is that the capex
bubble was pricked in the 2001 recession following the tech boom-bust cycle and there has been little new investment outside the real estate sector since. Corporate balance sheets are in very good health with high cash flows.
The 1907 recession too did not arise out of an over-production problem that has otherwise marked deflationary busts from the Great Depression to the Asian meltdown in 1997-98. The panic of 1907 is the most relevant template for the current crisis as it was largely the result of a credit bubble burst in the financial sector. If the 1907 analogy holds, then the US is likely to experience a recession of 3-4 quarters, beginning with the third quarter of 2008.
The global nature of the credit crisis implies the entire world economy will remain in recession territory till the second half of next year. But as the 1907 experience shows, once some confidence is restored in the financial system — and the odds are that the might of the global policymakers will eventually prevail — stock markets can start to recover well before the world economy turns around. After all, 1908 was one the best years in history for the US stock market.
(The author is head of emerging markets at Morgan Stanley Investment Management)