"Paradigms of Panic"

Before getting to the main point, "Paradigms of Panic," it will be helpful to start with some definitions. First, not all bank runs are alike:

Bank runs come in two kinds.

In some cases, the bank run is a pure self-fulfilling prophecy: the bank is “fundamentally sound,” but a panic by depositors forces a too-hasty liquidation of its assets, and it goes bust. It’s as if someone calls “fire!” in a crowded theater, provoking a stampede that kills many people, even though there wasn’t actually a fire.

In other cases, the bank is fundamentally unsound — but the bank run magnifies its losses. It’s as if someone calls “Fire!” in a crowded theater, and there really is a fire — but the stampede kills people who would have survived an orderly evacuation.

We also need to distinguish traditional bank runs from their modern counterparts. Traditional bank runs are fairly familiar and are described in more detail below, but what do modern bank runs look like? Here's an example involving hedge funds from something I wrote in the past. (It's slightly edited. The term "bank-like function" in the first sentence means financial intermediation. Most of the discussion of financial intermediation is about temporal intermediation, i.e. borrowing short and lending long, but intermediaries can also aggregate and smooth risk, aggregate small deposits into large loans, and lower transactions costs):

Entities outside the traditional banking sector have been engaged in bank-like functions and are hence subject to bank-like problems such as bank-runs.

For example, hedge funds can be hit with withdrawals even if they are not in trouble themselves, at least initially, due to uncertainties about the future state of the market, rumors, etc.

But like a bank who lends out most of the deposits it receives and only keeps a fraction of the deposits on hand as reserves, a hedge fund uses the deposits it receives to purchase securities and other assets for its portfolio maintaining some as a cash reserve. But unless it has substantial cash reserves on-hand, when investors make withdrawals the fund must begin to liquidate its portfolio to pay them off.

But if nobody will purchase mortgage-backed securities you are offering, who do you sell to? With nobody buying the assets the fund is trying to sell, they are forced to try to raise cash in other ways, and problems mount.

And it can feed on itself, just like a bank run. If investors hear that people are having trouble getting their money out of a particular fund, or from funds generally, they will rush to get their money out before the fund fails, and the problems spread as funds try to sell assets to raise the needed cash.

So it's sort of like a bank run, but without a standing lending facility (i.e. the equivalent of a discount window) available to meet the demand for liquidity, though such institutions could be created.

And they have been created.

Next, the "New World Order" and how to save the free world:

Paradigms of Panic Asia goes back to the future, by Paul Krugman: 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?

And I should break in and note this explanation of how bank panics happen is from 1998. But if you think in terms of modern bank runs rather than bank runs on traditional institutions, the same basic mechanisms apply:

...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 ... 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. ... 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. ...

But what worries me ... is the thought that we may have to get used to such crises. Welcome to the New World Order.

Update: How to save the free world:

Why AIG Must Be Bailed Out, Unsettling Economics: Suppose somebody wants to make a bet with me that the San Francisco 49ers will win the next two Super Bowls. He gives me $100 today, and I have to give him $100 million in case he’s right. The chances of this happening are very small, but just in case the impossible happens I want some backup. I buy insurance from my next-door neighbor. I offer to give him a nickel every week in return for his promise to cover my bet.

My neighbor sees that he has a good thing going — getting money for nothing. After a while he takes on more and more bets until others follow in his footsteps. Soon, a market develops. In effect, people can bet on bets. Eventually, the total potential amount of money builds up into the billions and trillions of dollars.

Unexpectedly, the San Francisco 49ers win two Super Bowls in a row. My neighbor does not have $100 million on hand to cover my loss. The nickels I have been giving him have been wasted. I don’t have $100 million either.

Suddenly everybody in the market is worried about people’s ability to back up their bets. The Federal Reserve steps in and takes over the market. The free world is saved.

Comments

[hari]

I think your 49er bet is moving in the right direction (after what they did to Seattle!)...namely, spreading the financial risk globally. And the more we can link up the global financial system via their institutional structures and whatnot, the sooner we shall be able to get a better grip on the right mix of policy framework.

EU will now enforce regulatory regime under its own policy cooperation with member countries CBs. Until now there was no central regulatory framework...and it will take time to put it in place.

Panic, as I know too well, is no framework for serious policy deliberations.

[Illusion]

"I buy insurance from my next-door neighbor."

It should be obvious that this is just the illusion of insurance. What national gain comes from perpetuating the illusion of insurance? The illusion that Ned neighbor can protect them for 5 cents per week encourages people to take foolish risks. Better to regulate insurance providers so only people who can actually pay off claims can offer insurance.

[Robinia]

Illusion, we tried that-- the "names" of Lloyd's of London, remeber? It worked for quite a while, but not forever-- kind of depends on hereditary transmission of wealth which is, well, kinda feudal (futile?).

Good morning, you own the insurer; if you are a US citizen, you are now one of the new "names." You, and your neighbor next door. Turns out, all we really have to rely on is each other. So, buck up and do your part.

[ken melvin]

Insurers no longer have reserves. What we have is a "cluster f**k".

[hari]

I think there is a good chance of Congressional paradigm shift towards greater regulatory control and whatnot on high street. It seems the political pendulum swings with each crisis - rather than trying to come to grips with the fundamentals of a globalized financial market. Obviously there are things that can be better regulated before they get out of control or how fradulent means are used to endanger the financial system.

I notice, for example, EU is only now taking up the Solvency II regulatory report dealing with insurance and mutuals. Of course, this is a knee-jerk reaction after AIG meltdown and will require a very detailed study of the sector before regulatory regime can be effectively put into place...pros and cons of which are always difficult to separate from objective criteria.

[Finite Supply]

There is only so much credit available in the world. Voluntary savings by individuals, supplemented by forced savings via monetary expansion channeled to loans. If the available credit is wasted inflating bubbles, there will not be enough left to expand production/finance consumer purchases.

[ken melvin]

Seems to me:

If ‘A’ holds assets that include $1million of ‘B’ paper and that $1million includes $0.5million of ‘A’ paper, the asset held by ‘A’ is only worth $0.5million.

Further, if the other $0.5million of the $1million of ‘B’ paper is premised on ‘C’ and ‘D’ paper and one-half these of each was premised on ‘A’ paper assets, then the asset held by ‘A’ is only worth $0.25million.

Und so weite.

[dd]

Well, panic is here. Even McCain is forced to utter the "R" word...no not recession but regulation:
McCain, 72, who calls himself a ``deregulator'' and argued in February for the need to ``keep government out of these issues and policies,'' is proposing new market supervision.
``Too many firms on Wall Street have been able to count on casual oversight by regulatory agencies and government,'' he said at an event in Tampa, Florida. ``Under my reforms, the American people will be protected by comprehensive regulations that will apply the rules and enforce them in full.''
http://www.bloomberg.com/apps/news?pid=20601087&sid=aqwxDPvmIvDc&refer=home

[Eric Dewey]

Mark, the Super Bowl bet analogy is an exaggeration that is seriously, and fatally, flawed.

First, anyone willing to take such a bet has failed to adequately consider the possibility that the person offering the bet is in possession of specialized information, or has the capability of affecting the outcome of football games. Their motivation is not to make a good bet, but simply to take money from someone that appears to be foolishly giving it away. As the great economist W.C. Fields observed, You can't cheat an honest man.

Second, anyone willing to backstop such a bet, let alone backstopping such bets repeatedly, is arguably engaged in fraudulent behavior, because it is more likely than not that they entered into a contractual relationship without the intent to perform under the terms of the contract.

In the absence of evidence demonstrating actual capability to perform as of the date that the contract was created, the fraud could be considered a criminal offense.

The Fed's actions in bailing out AIG amount to nothing more or less than providing government sanction to arguably criminal activity.

Yes, this type of betting is the reason the financial mess has occurred.

No, the Fed is not "saving the day" - they are postponing it, and making it worse.

Krugman asks: "Why, then, did the ... 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. ... Yet governments are no more stupid or irresponsible now than they used to be; how come the punishment has become so much more severe?"

Krugman gives only part of the answer to this question. Another part of the answer is that the existence of the FDIC allowed moral hazard to become larger and larger until it has become what it is today - the nationalization of the world's largest insurance company.

I'm not arguing against FDIC insurance; that was enacted after the crisis hit in the 1930's, when Congress had a chance to set policy after considering both sides of the question.

And I agree that stopping a universal meltdown in the financial sector might be a good idea - as long as it does not set a precedent that we will later regret.

But unilateral decisions by the Fed in the midst of the crisis to establish the policy of bailing out and nationalize corporations, or subsidize takeovers by other corporations, is not in any way similar to establishing the FDIC.

This action makes it extremely clear to foreign countries, and to the poor and middle class of the world, that the elites of the world, which does include academics and government bureaucrats, have no real commitment to the high-minded principles they espouse.

Taking a bandaid off slowly hurts much, much worse than a quick rip. Adjusting to cold water when swimming takes much longer if you don't dive right in.

Would you rather die slowly of suffocation by emphysema, or lose your mind gradually to dementia, knowing that your loved ones will have to watch it happen to you but be powerless to help - or be taken quickly by a heart attack?

[SGC]

The real panic is evidenced in the commercial paper markets/ money market funds. I think the government needs to allow Treasury and GSE money market funds to put their funds into FDIC insured CDs so that the money gets recycled back to the banks.

[kotika98]

It seems to me that nobody exactly knows exactly what regulations are needed, though everybody agrees that some are definitely needed. Its just like after Enron, nobody had a clue, so now we have Sarbanes-Oxley but it didnt save us from this crisis, did it? We can be sure that some hasty compromise will be worked out between Democratic Congress and Republican President and it will ensure that no crisis of confidence will ever hit investment banks and mortgage lenders again, but sure as a clock, a few years will pass and another financial hurricane will hit, from a completely "unexpected" direction...

But is it really so "unexpected"? Perhaps the root cause is that the savings rates in the western world are too low, and all the burden and benefit of risky activities goes to financial institutions and rich individuals? In a previous era, that is before 1970 majority of stock in American corporations was owned by individual big and small investors, and likewise most of the wealth of many developing nations is in the hands of private individuals. So, from this point of view the existence of financial intermediaries with too much leverage and taking on too much risk is perhaps because average middle class person does not invest in stocks, bonds and mortgages in his own name -- he/she puts it in a bank CD which money then gets recycle into all kind of risky activities by the bank...

But what is the cure? Maybe we dont really need a cure... if these financial panics and bank runs are so frequent, maybe we should just let them run their course? i.e. one every 20 years and then followed by another 20 year run of fast economic growth which would not be possible without the benefits of a flexible, innovating financial system. Which do you prefer: a steady but unexciting growth of 2%, or long periods of fast growth of 4-5% followed by violent crisis?

By the way Karl Marx wrote
his Das Kapital right after the crash of the railroads sometime in 1860's, and supposed that it prooved that capitalism is prone to crisis and therefore unworkable system... I think there is now ample evidence that free-market system is indeed prone to crisis, but also that every next economic boom brings ever greater prosperity.