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As we look back upon the financial crisis and reassess the developments that subsequently shaped the present day, hidden agendas and political gamesmanship can lead us to ignore the overwhelming seriousness of the events surrounding the Panic of 2008 and obscure opportunities that may continue to pave the pathway to recovery.
So it still may be helpful to ponder the key characteristics of this financial debacle, identifying the similarities to and differences from other crises and perhaps find reason to be grateful for the decisive actions of key members of two administrations of opposing parties who generally were forced by stressful and unfamiliar circumstances to lead us through largely uncharted territory.
Anticipation and the Business Cycle
Warren Buffett anticipated the financial crisis in a 2002 letter to shareholders that read in part:
“History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times … Linkage, when it suddenly surfaces, can trigger serious systemic problems. … Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
An enormously complex global system built of a mountain of derivatives, the “shadow banking system,” completely froze in the aftermath of the Lehman Brothers failure, and traditional institutions faced the threat of capital shortages and, in some cases, imminent failure. Due to unexpected linkages, excessive leverage fueled a downward asset price spiral that was in some cases far removed from the subprime mortgage market where the crisis originated. The financial markets lost trust and confidence. As a result, commercial paper could not be issued or renewed and money markets were immobilized. Decisive government action was required if severe economic consequences were to be avoided.
The calamity sprung from a uniquely complex financial system with global links and was provoked and exacerbated by extravagant leverage. Globalization and unprecedented levels of complexity distinguish our financial system from its predecessors. Yet a cursory review of U.S. economic history reveals a stubborn cycle that culminates in financial crises of varying depth and perseverance. The underlying strength of capitalism anchored within a free society endures in spite of occasional bouts of poorly regulated greed, leverage-enhanced mania and the subsequent threat of financial collapse. This financial debacle that produced the Great Recession, although severe, was not without precedent.
In fact, the occasional threat of calamity within the business cycle has long been recognized as the price we pay for a system that encourages, supports and validates entrepreneurial endeavors. A few years before the Panic of 1907, the following comment appeared in a popular publication of the day, World’s Work:
“Every twenty years there has been a great panic in this country, and midway between these great panics there have been smaller convulsions, so that, on an average, every tenth year of our business history has been a year of declining activities attended with more or less of loss and disaster.”
The Panic of 1907 resulted in the creation of the Federal Reserve in 1913 in the hope of softening, if not eliminating, the sharp volatility of the business cycle.
More recently, the investment markets have confronted numerous challenges that have tested the resiliency of the economy and the financial markets. The inflation of the 1970s, back-to-back recessions and the Mexican currency crisis in the early ’80s, the “crash” of 1987, the savings and loan crisis of the 1980s and the junk bond debacle of 1990, the Russian default and failure of long-term capital in 1998, and the new millennium’s dot-com bust all had powerful effects on financial markets domestically and worldwide. While each of these events was accompanied by dire predictions and commanded expansive media attention, the financial markets recovered. With occasional assistance from government and private sources, the markets have continued to function, and history has shown that the capital markets can respond creatively to incredibly adverse circumstances. But these examples, although menacing, were not systemwide “panics.”
Too Much Leverage
The recent onset of panic was distinguished by its global scope and the imminent breakdown of the financial system resulting from too much speculative leverage. As leverage is unwound, vicious feedback loops may develop as collateral is questioned, more capital is required and forced liquidations lead to lethal asset price spirals. In the attempt to control risk, particularly as our financial system has grown in complexity, regulation may actually exacerbate these “natural accidents” by requiring that capital levels be maintained while enforcing “mark to market” accounting.
At the same time, the government’s role as lender of last resort is tested. Although actions on the part of the Fed and Treasury are sometimes thought to inspire “moral hazard” and to diverge from free-market principles, reluctance to act would likely have considerably deepened the severity and duration of the crisis. Some consider such reluctance to have been a major contributing factor to the Great Depression. If the Federal Reserve failed its first real test in 1929, in 2008, led by a scholar of that earlier embarrassment, it was determined not to do so this time. In any case, we can appreciate that the Federal Reserve and the Treasury ultimately acted resolutely and that two presidential administrations and Congress reluctantly allowed them the room to do so.
Recovery and the Future
In the thick of the 2008 panic, some experts like John Mauldin, author of “Betting on Financial Armageddon,” predicted a recovery.
“The crisis on Wall Street will pass and the world will continue to change,” he said in September of that year. “I think it is going to change for the better for most people.”
To date, the real economy and the capital markets have responded favorably. Employment continues to rebound, the bond market seems stable, and equity indexes have recuperated. “Financial Armageddon” appears to have been avoided.
No one knows what the Wall Street landscape will look like in one, five or 10 years, but history has shown that the irrepressible vitality of the American people should not be underestimated. In the meantime, we can remain grateful for the decisive action of public servants of both political parties in avoiding catastrophe. In this politically polarized climate, perhaps that is something worth celebrating.