Paradigms of Panic
There were warning signs
aplenty. Anyone could have told you about the epic corruption--about tycoons
whose empires depended on their political connections and about politicians
growing rich in ways best not discussed. Speculation, often ill informed, was
rampant. Besides, how could investors hope to know what they were buying, when
few businesses kept scrupulous accounts? Yet most brushed off these well-known
vices as incidental to the real story, which was about economic growth that was
the wonder of the world. Indeed, many regarded the cronyism as a virtue rather
than a vice, the signature of an economic system that was more concerned with
getting results than with the niceties of the process. And for years, the faint
voices of the skeptics were drowned out by the roar of an economic engine
fueled by ever larger infusions of foreign capital.
The
crisis began small, with the failure of a few financial institutions that had
bet too heavily that the boom would continue, and the bankruptcy of a few
corporations that had taken on too much debt. These failures frightened
investors, whose attempts to pull their money out led to more bank failures;
the desperate attempts of surviving banks to raise cash caused both a credit
crunch (pushing many businesses that had seemed financially sound only months
before over the brink) and plunging stock prices, bankrupting still more
financial houses. Within months, the panic had reduced thousands of people to
sudden destitution. Moreover, the financial disaster soon took its toll on the
real economy, too: As industrial production skidded and unemployment soared,
there was a surge in crime and worker unrest.
But why am I telling you what happened to the United States
125 years ago, in the Panic of 1873?
Anyone who claims to fully
understand the economic disaster that has overtaken Asia proves, by that very
certainty, that he . The truth is that we have never seen anything quite like
this, and that everyone--from the country doctors at the International Monetary
Fund and the Treasury Department who must prescribe economic medicine to those
of us who have the luxury of irresponsibility--is groping frantically for
models and metaphors to make sense of this thing. The usual round of academic
and quasiacademic conferences and round tables has turned into a sort of
rolling rap session, in which the usual suspects meet again and again to trade
theories and, occasionally, accusations. Much of the discussion has focused on
the hidden weaknesses of the Asian economies and how they produced fertile
ground for a financial crisis; the role of runaway banks that exploited
political connections to gamble with other people's money has emerged as the
prime suspect. But amid the tales of rupiah and ringgit one also hears
surprisingly old-fashioned references--to Charles Kindleberger's classic 1978
book Manias, Panics, and Crashes , and even to Walter Bagehot's
Lombard Street (1873). Asia's debacle, a growing number of us now think,
is at least in part a souped-up modern version of a traditional, 1873-style
financial panic.
The logic
of financial panic is fairly well understood in principle, thanks both to the
old literary classics and to a 1983 mathematical formalization by Douglas
Diamond and Philip Dybvig. The starting point for panic theory is the
observation that there is a tension between the desire of individuals for
flexibility--the ability to spend whenever they feel like it--and the economic
payoff to commitment, to sticking with long-term projects until they are
finished. In a primitive economy there is no way to avoid this tradeoff--if you
want to be able to leave for the desert on short notice, you settle for matzo
instead of bread, and if you want ready cash, you keep gold coins under the
mattress. But in a more sophisticated economy this dilemma can be finessed.
BankBoston is largely in the business of lending money at long term--say,
30-year mortgages--yet it offers depositors such as me, who supply that money,
the right to withdraw it any time we like.
What a financial intermediary (a bank or
something more or less like a bank) does is pool the money of a large number of
people and put most of that money into long-term investments that are
"illiquid"--that is, hard to turn quickly into cash. Only a fairly small
reserve is held in cash and other "liquid" assets. The reason this works is the
law of averages: On any given day, deposits and withdrawals more or less
balance out, and there is enough cash on hand to take care of any difference.
The individual depositor is free to pull his money out whenever he wants; yet
that money can be used to finance projects that require long-term commitment.
It is a sort of magic trick that is fundamental to making a complex economy
work.
Magic, however, has its
risks. Normally , financial intermediation is a wonderful thing; but now
and then, disaster strikes. Suppose that for some reason--maybe a groundless
rumor--many of a bank's depositors begin to worry that their money isn't safe.
They rush to pull their money out. But there isn't enough cash to satisfy all
of them, and because the bank's other assets are illiquid, it cannot sell them
quickly to raise more cash (or can do so only at fire-sale prices). So the bank
goes bust, and the slowest-moving depositors lose their money. And those who
rushed to pull their money out are proved right--the bank wasn't safe,
after all. In short, financial intermediation carries with it the risk of bank
runs, of self-fulfilling panic.
A panic,
when it occurs, can do far more than destroy a single bank. Like the Panic of
1873--or the similar panics of 1893; 1907; 1920; and 1931, that mother of all
bank runs (which, much more than the 1929 stock crash, caused the Great
Depression)--it can spread to engulf the whole economy. Nor is strong long-term
economic performance any guarantee against such crises. As the list suggests,
the United States was not only subject to panics but also unusually
crisis-prone compared with other advanced countries during the very years that
it was establishing its economic and technological dominance.
Why, then, did the Asian crisis catch everyone by surprise?
Because there was a half-century, from the '30s to the '80s, when they just
didn't seem to make panics the way they used to. In fact, we--by which I mean
economists, politicians, business leaders, and everyone else I can think
of--had pretty much forgotten what a good old-fashioned panic was like. Well,
now we remember.
I'm not
saying that Asia's economies were "fundamentally sound," that this was a
completely unnecessary crisis. There are some smart people--most notably
Harvard's Jeffrey Sachs--who believe that, but my view is that Asian economies
had gone seriously off the rails well before last summer, and that some kind of
unpleasant comeuppance was inevitable. That said, it is also true that Asia's
experience is not unique; it follows the quite similar Latin American "tequila"
crisis of 1995, and bears at least some resemblance to the earlier Latin
American debt crisis of the 1980s. In each case there were some serious policy
mistakes made that helped make the economies vulnerable. Yet governments are no
more stupid or irresponsible now than they used to be; how come the punishment
has become so much more severe?
Part of the answer may be that our financial
system has become dangerously efficient. In response to the Great Depression,
the United States and just about everyone else imposed elaborate regulations on
their banking systems. Like most regulatory regimes, this one ended up working
largely for the benefit of the regulatees--restricting competition and making
ownership of a bank a more or less guaranteed sinecure. But while the
regulations may have made banks fat and sluggish, it also made them safe.
Nowadays banks are by no means guaranteed to make money: To turn a profit they
must work hard, innovate--and take big risks.
Another part of the
answer--one that Kindleberger suggested two decades ago--is that to introduce
global financial markets into a world of merely national monetary authorities
is, in a very real sense, to walk a tightrope without a net. As long as finance
is a mainly domestic affair, what people want in a bank run is local
money--and, guess what, the government is able to print as much as it wants.
But when Indonesians started running from their banks a few months ago, what
they wanted was dollars--and neither the Indonesian government nor the IMF can
give them enough of what they want.
I am not
one of those people who believes that the Asian crisis will or even can cause a
world depression. In fact, I think that the United States is still, despite
Asia, more at risk from inflation than deflation. But what worries me--aside
from the small matter that Indonesia, with a mere 200 million people, seems at
the time of writing to be sliding toward the abyss--is the thought that we may
have to get used to such crises. Welcome to the New World Order.
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