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Sunday, October 19, 2008

Panic, Fear and Financial Crisis

Edward Chancellor of GMO looks back in history of the similarities in financial crises.

"The passion of fear," declared The Times on the day of Overend's collapse, "is even more powerful than that of hope. There are men who can resist the seductions of promised profits and high premiums, but when depositors think a stoppage is imminent each rushes to secure his deposit in time, caring little for the consequences. Not long ago men trusted everybody; it would seem now that they trust nobody. A great machinery is thrown out of gear."

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The financial panic we have been living through has much in common with the great banking panics of the past: rumours of foundering financial giants, concerns about counterparties, the shepherding of cash and flight to the highest quality and most liquid credit instruments, the dumping of riskier assets regardless of price, international contagion and, above all, a heightened sense of the fragility of a weakened financial system. Yet this panic will pass, just like its predecessors.

Bank panics always have the same origin. "Every genuine business panic springs from the same root, which is rank speculation," wrote one Victorian commentator. Thomas Tooke, the ­early 19th century merchant and author, ascribed the British crisis of 1793 to "a great and undue extension of the system of credit and paper circulation". A year earlier, Thomas Jefferson, observing the first financial collapse in the independent United States, noted that "our paper bubble has burst".

Bank panics invariably reveal the poor quality of lending that accompanied the preceding boom. Walter Bagehot, the greatest of 19th-century writers on finance, was aghast at the stupidity of the directors of the discount house Overend Gurney, whose failure in 1866 was the cause of the last run on a British bank before the ignominious demise of Northern Rock. "They ruined a firm almost inconceivably good by business so inexplicably bad that it could hardly be much worse if they had of set purpose tried to make it bad," wrote Bagehot.

The behavioural characteristics of the panic are the obverse of those of the boom. Excessive confidence is replaced by extreme fearfulness and a nervous distrust takes the place of blind trust. During the panic, the buying frenzy of the boom gives way to panicky disposals.

Loss aversion becomes extreme during the panic. "The passion of fear," declared The Times on the day of Overend's collapse, "is even more powerful than that of hope. There are men who can resist the seductions of promised profits and high premiums, but when depositors think a stoppage is imminent each rushes to secure his deposit in time, caring little for the consequences. Not long ago men trusted everybody; it would seem now that they trust nobody. A great machinery is thrown out of gear."

The machinery is thrown out of gear by the failure of what economists would call a systemically important financial institution, such as the Ayr Bank in June 1772, Pole Thornton & Co in December 1825, Overend Gurney in May 1866 (which The Times called "the greatest instrument of credit in the Kingdom"), Jay Cooke & Co in September 1873 and the downfall of the Bank of the United States in December 1930. Likewise, the bankruptcy filing of Lehman Brothers on September 15 triggered our current panic.

The main consequence of the panic is a wild scramble for liquidity. Money becomes scarce. This was even more pronounced when currencies were convertible into gold: in every panic, there was too little of the precious metal to go round. Interest rates rose and the securities prices collapsed. "The best mortgages cannot be converted into money without a sacrifice of 20 per cent, and undoubted business paper is selling in Wall Street at a discount of 3 per cent a month," wrote the New Yorker Philip Hone during the panic of November 1837. Call money rates reached 100 per cent in October 1907.

Every panic is marked by a sense that the financial system is close to complete collapse. Never were such feelings more marked than during the panic that started in London in December 1825. "If the difficulties which existed in the money market had continued only eight-and-forty hours longer ..." William Huskisson, the president of the Board of Trade, told the House of Commons, he sincerely believed "that the effect would have been to put a stop to all dealing between man and man, except by way of barter." Or, as a director of the Bank of England put it during the midst of the crisis: "We must ask not who is gone, but who stands?"

Yet even in 1825 the authorities belatedly succeeded in quelling the panic in that incident by borrowing money from France and distributing a stash of old banknotes found in the vaults of the Old Lady. In the 20th century, the end of the panic tended to coincide with decisive government intervention: Roosevelt's bank holiday of March 1933, the launching of the Bank of England's "lifeboat" in December 1974 and the nationalisation of Japan's Long-Term Credit Bank in October 1998, which was accompanied by a $500bn capital injection into the stricken banking system.

There is good cause for concern. Our modern credit system is more complex, more interconnected and more leveraged than in earlier times. On the other hand, the measures taken by the authorities to allay the crisis are far more extensive than on earlier occasions. Witness the wild scramble by governments around the world to guarantee bank debts, provide loans against dubious securities and inject capital into stricken financial firms.

It is important not to exaggerate the dangers. Dr Johnson dismissed the "general distrust and timidity" on display in 1772 as "little more than a panick terrour from which when they recover, many will wonder why they were frighted". The current panic will pass as others have done beforehand. This does not mean the aftermath will be pleasant for the wider economy. Emergency measures may allay the panic but they cannot correct the credit excesses that are the root cause of the crisis.

The writer is a member of GMO's Asset Allocation team