Wednesday, July 16, 2014

How to Start a Financial Crisis

How Financial Crises Start, Part 1 by Market Authority

Today is the start of a multi-part series on the financial crisis: what was the cause and what have we learned.

When I lived overseas, I was the proud owner of a 1982 Toyota FJ40. Designed as an offroad vehicle, this 4-cylinder diesel could climb just about anything. I’m no gearhead, so once the truck started experiencing problems, fixing it was quite the learning experience. Some issues were easy to fix, such as replacing cheap glow plugs with a higher quality set or a worn down hose with a newer one. While I’m still not an expert on diesel engines, I’m now more familiar with how they operate and can diagnose simple problems when they arrive. The universal truth is that nobody really wonders how the engine works until it fails to start in the morning.

And the same principle applies to financial markets. Only when a crisis happens, do we pop open the hood and take a look at the problems with the system. We discover issues that a previous mechanic may have installed incorrectly or parts that need to be entirely replaced due to overuse. Some of these may be quick fixes while others may require a complete rebuild.

Every financial crisis starts with a complete loss of confidence in what’s under the hood. When fear is prevalent, investors sell assets and raise cash. Because of this action, the economy loses the financing necessary to grow and output falls.

The financial crisis of 2008 allowed us to diagnose the problems in our financial system and propose solutions to avoid similar events in the future. This is how economic systems evolve, through a crisis/recovery process leading to a better understanding of how the entire system operates.

For instance, before the Federal Reserve was created in 1914, bank runs were a national pastime. At every peak in the business cycle, depositors would worry that their local bank had underwritten too many bad loans. Fearing their cash was no longer safe, they would line up outside the local bank demanding their money back. This was a powerful signal. If you were walking through town and witnessed your neighbors waiting anxiously (and sometimes angrily) in line, you were likely to inquire what all the fuss was about. When you were told your money was at risk, you would likely join the line, reinforcing the signal. The risk of losing all of your deposit was much greater than the reward earned from keeping it in the bank.

In a fractional reserve banking system, banks never keep enough deposits on hand to pay everyone back at the same time. They don’t need to, unless a crisis occurs and all depositors are suddenly fearful of what might happen to their deposits. The bank run became a self-fulfilling prophecy, with the bank usually closing down, halting withdrawals, and declaring a “bank holiday” while it went about selling assets (in a fire sale) to raise the cash needed to satisfy withdrawals. As a result, the bank would usually close and it would take years for a new bank to repair relations with depositors and get the economy moving again.

This is essentially why the Fed and FDIC insurance were created: to stop bank runs and smooth out the business cycle. The Fed will provide the needed liquidity for the bank (they can borrow at the discount window) and the FDIC gives depositors the peace of mind that their cash will always be protected. If a crisis occurs, there’s no longer a need to withdraw your cash and bury it in the backyard. Thus, the bank runs of the 19th Century are all but extinct.

The Federal reserve as a backstop and FDIC insurance led to what Yale economist Gary Gorton describes as “the Quiet Period” in our economy: the period from 1934 to 2007 when “properly designed bank regulations prevented financial crisis for a significant period of time, until innovation and change necessitated their redesign”. Crisis brought about an evolution in understanding, which allowed for the development of regulatory systems targeted at preventing future crises.

And things got really quiet towards the end of the quiet period during the “great moderation”. Between the mid-1980s and 2007, economic volatility declined dramatically. The Fed had seemingly smoothed out the business cycle.

While economists understood some of the factors causing the great moderation (central bank independence and counter-cyclical economic stabilization), they didn’t foresee the problems under the hood until the 2008 financial crisis occurred.

Tomorrow, we’ll take a look under the hood and discuss the shadow banking system. This will allow us to understand how bank runs can still occur in the 21st Century.

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