To the New Administration: Have Past Crises Taught us Anything?

Monday, November 24, 2008

A scholar who has studied the relationship between political and financial fortunes suggests that we take a good, hard look at the aftermath of the Great Depression -- and learn.
By Jon Markman

American banking titans Citigroup (C, news, msgs), Goldman Sachs (GS, news, msgs) and Morgan Stanley (MS, news, msgs) are each down 30%-plus this month despite emergency rescue efforts by two branches of the federal government and the infusion of tens of billions of taxpayer dollars.

They are down 75% for the year despite executives' protests that business is fine. They are down despite massive job cuts and asset sales to save costs, and the personal endorsement of everyone's favorite rich uncle, Warren Buffett. They are down even though they have plenty of cash flow and millions of customers, many of whom are the envy of other banks the world over.

Investors must be nuts, right? I mean, they must not have gotten the message that the Treasury and the Federal Reserve will use all means at their disposal to recapitalize the banking system. They didn't see the memo that says the feds have never failed in their efforts to pump the system full of money until it bursts like a piñata, spilling profits in every direction.

Yet according to research by Niall Ferguson, a Harvard professor of economic history, there is ample reason for investors to thumb their noses at the conventional wisdom: All that taxpayer money is acting more like embalming fluid than artificial respiration, he says, keeping the banks looking eerily lifelike while they stiffen.

Turning Japanese

"You can stick money into every orifice of the big banks -- their mouth, their nose, their ears, wherever -- but if they can't make loans because they have to reserve against=2 0future losses, and if they won't make loans because there's a recession, it won't do any good," Ferguson says. "If they can't lend, there's no money multiplier -- they're stuck, they're zombies. It's Japan all over again."

That sounds about right. It's the night of the living dead on Wall Street these days, a few weeks past Halloween, as the horror of asphyxiated credit that has plagued Japan since a debt bubble burst in 1990 is playing out all over again here. While it's bad enough that our banks aren't lending and private fund managers are shunning corporate bonds, it's doubly concerning because U.S. policy experts have sworn they would never repeat Japan's mistakes.

Ferguson, a fellow at Stanford and Cambridge universities when he's not lecturing at Harvard, is not surprised to see this fate befall U.S. banks because he has documented a similar set of circumstances that played out in a dozen financial crises of the past 10 centuries. In his new book, "The Ascent of Money," he tells how the bipolar moods of the credit cycle -- the expansion and contraction of money and lending -- explain much of the political history that is more widely studied.

Every time governments and bankers figure out how to create money from thin air -- or out of the ground, for that matter -- they get carried away, running a thousand miles an hour until they hit a brick wall. Then the old world of finance shatters into a thousand pieces, and despite the best efforts of the smartest minds at the time, it takes many years, at best, for institutions and psyches to heal.

It happened in the 15th century after Spain discovered silver in South America and used it to finance endless wars that ended in ruin. It happened in the 1870s when U.S. banks suffered a depression after railroad and agricultural financing went bust. And it happened in Japan in the 1980s when loans on real-estate speculation went bust.

Ferguson observes that the experts of each era swear they will never repeat their predecessors' mistakes, yet they always end up making new errors of hubris and find that some old missteps are unavoidable. The U.S. Treasury and the Fed both know, for instance, that one key error made in the 1930s was the passage of a set of protectionist laws that prevented a free exchange of goods among countries, and they have overtly sworn to prevent that from happening. Yet20at times of stress, new populist leaders always emerge, and they find it politically useful to blame foreigners for the country's economic problems and try to protect jobs in the homeland.

A global race to the bottom

Ferguson says he recently appeared on a CNN show hosted by anti-immigration demagogue Lou Dobbs and found the scorching critique of free trade, bankers and immigration to be eerily similar to screeds that ultimately led Congress to pass the Smoot-Hawley Tariff Act in 1930. That law backfired by smashing world trade and catalyzing a decade-long depression.Think history can't repeat?
  • President-elect Barack Obama pledged during his campaign to withdraw from the North American Free Trade Agreement until he has a chance to overhaul it.
  • Leaders of the top 20 world economies met in Washington, D.C., last weekend and emerged with no firm plan to coordinate on interest-rate cuts or currency balances.
  • Russia has sworn to prevent its banks from making good on obligations to the United States and the EU.
  • And Ecuador's president has said he would ignore "illegitimate" Wall Street claims for bond repayments.
Ferguson says that if history is any guide, the next steps taken by countries in an attempt to revive domestic economies will be to weaken their currencies. This makes exports cheaper, boosting sales, but it cannot be done by every country at the same time, or chaos ensues -- and sometimes land grabbing.

"We will have a race to the bottom as every country tries to avoid depression," Ferguson says.

Policymakers throughout history have found few good choices once the unwinding of debt, known as deleveraging, replaces debt creation as the central theme of global trade. Debt buildup is a raucous party that makes borrowers happy and rich on paper; debt unwinding is a wake that leaves ex-borrowers bummed and truly poorer. Because the Fed has probably not figured out how to outlaw the credit cycle, we might think of the last 25 years as rock 'n' roll and the next decade as Mahler.

Japan has been able to withstand the past 18 years of extremely slow growth or contraction without social unrest because it was already a homogenous, orderly welfare state in which people were avid savers and accustomed to living in small apartments. Ferguson expects the transition to a credit famine in the United States to be a lot harder.

Although there won't be Hoovervilles, a dust bowl or ex-executives selling pencils, he says, there could well be a lot of angry nationalism and disorderliness as Americans shake their fists at Wall Street and Washington, battle each other, bristle at the world and learn unhappily to save instead of borrow.

Ferguson concludes that "unless we're careful, it'll be the late 1930s re-enacted," by which he means a path to world war. Yet he's optimistic that policymakers will avoid that mess by learning from history that they must cooperate instead of isolate.

"We have to stare at this possibility and say, 'Oh, my God, we cannot go there,'" he says. Let's hope the market gods are listening.

Fine print


Does Wall Street's meltdown presage the end of the American century? Many commentators have warned that the past week's financial mayhem signaled a major political setback for the United States as well as an economic one. 'Why should the rest of the world ever again take seriously the American free-market model after this debacle?' a leading British journalist asked me [Furgason] last Thursday. This crisis, he argued, was to economics what the Iraq war was to U.S. foreign policy: a fatal blow to the credibility of American claims to global primacy..."

To learn more about Ferguson's views, visit his Web site. He's a prolific and good writer; check out his journalism. Learn more about Japan's post-1990 depression here and here and here

Recommend Niall Ferguson's new book: The Ascent of Money


Civilization's Last Call