Surviving a financial panic -- lessons from the past
   
   Posted October 13, 2008 - 05:44 by Philip Brewer
   
   
   Financial panics used to be quite ordinary.  In the century or two prior
to the great depression, there was a panic every 15 or 20 years.  Since the
great depression we haven't had a classic financial panic, until now.
There's a thing or two that we can learn from panics past to help us survive
the current one.
    To begin with, there's a reason why we haven't had financial panics for
the past 75 years--fiat currency.
   
   Panics and gold
   
   Panics used to begin when people decided to get their hands on actual,
physical gold.  That could happen for a lot of different reasons.  Often it
was because there had been inflation--banks issuing bank notes far in excess
of the gold they had on deposit--and people decided that they didn't trust
their bank.  Sometimes, though, it happened without any particular
malpractice by the banks, simply because there was a demand for gold
someplace else--an economic boom in Europe or South America could drain
gold from the United States or vice versa.
   Since issuing banknotes was literally printing money, the temptation to
go overboard was immense, and individual banks that did so used to collapse
all the time.  A prudent bank, though, could be modestly profitable and a
great boon to its community, but in a panic, even prudent banks would fail.
(You could, in theory, create a panic-proof bank that held enough gold to
pay off every banknote, but it would be a money-losing institution.  Holding
all its gold in its vaults, it would be practically unable to make loans,
but would still having to pay for a building, tellers, security, and so
on.)
   Prior to 1933, it was very hard to address a panic, because there wasn't
enough gold.  Sometimes, if a panic started small, it could be headed off by
large banks (or even wealthy individuals) lending gold to the banks that
were under pressure.  The banks could then redeem enough banknotes to
satisfy worried note holders.  When the panic subsided, gold would flow back
to the banks, they could pay off the loan, and things would return to
normal.
   In the case of a large panic, though, the banking system as a whole
didn't have enough gold to redeem enough of the banknotes.  Banks would pay
out gold for a while, hoping that they could thereby demonstrate their
soundness. Once it became clear that the gold on hand wouldn't satisfy the
demands of note holders, the bank would suspend note redemption.  Note that,
even when that happened, depositors and note holders didn't necessarily lose
everything.  In many cases, the bank was actually solvent.  As their
customers went on paying their debts, gold would gradually flow back to the
bank, allowing it (at some point) to resume redeeming its notes.
   Since 1933, there hasn't been any gold backing the banknotes anyway, a
condition that had seemed to have eliminated the possibility of a classic
panic.
   And yet, here we are.  So, what were the keys to surviving a panic in
those days, and how do they apply today?
 
   Liquidity
   
   The first way a panic works its harm is by destroying liquidity.
   Once a panic started, the first things to go was the payments system.
In normal times, people could spend banknotes as easily as they spent gold
and could pay their bills with checks.  In a panic that isn't true.  Every
transaction becomes its own negotiation.  Payment in gold is fine
(although you have to be sure it's real gold).  Payment in the notes of a
sound bank is okay, but opinions differ regarding which banks are sound and
which aren't, leading to confusion and disagreement--the result is a whole
sliding scale from the sound banks to the iffy banks to the banks that have
suspended redemption of their notes but are still open to the banks that
have closed.   Checks have the same issue of bank soundness, only it's
layered on top of the question of whether or not you've got money in your
account.
    Adding that sort of negotiation on top of every transaction was
obviously a nightmare.  So, if you want to understand why central bankers,
finance ministers, and politicians are in such a tizzy, imagine layering
those issues on top of the complex payment systems that we use now.
    Today, checks are clearing, credit and debit cards work fine, the ATM
machines have money, direct deposits are going through on schedule,
automated clearing house payments for bill payments and bank transfers are
all working smoothly.  This is a huge win for the economy.   Just imagine
what happens if those systems start to break down--if your transfer from
your internet bank doesn't show up in your local bank, if your credit or
debit card starts being declined, if your landlord and the power company
stop  taking checks and start wanting you to show up in person with cash in
hand.
    If it was just liquidity, though, the problems would be manageable.
Cumbersome, but manageable.
 
   Solvency
   
   The second way a panic works its harm is by destroying solvency.
   As a panic began to set in, a business with merely adequate capital
could suddenly find itself on the ropes.  Its customers would start paying
at the last possible moment, and then start paying late (and, in many cases,
going bust and not paying at all).
   At the same time, its suppliers would start cutting credit limits,
pressing for early payment, and then demanding payment in cash.  On top of
that, its bank would refuse to lend.  If you had the cash to bridge the
gap--paying your bills on time, even though people were paying you
late--then you were fine.
   It wasn't that simple, of course.  If your bank failed it didn't make
much difference how much money you had.  The wealthy could take
measures--dividing their money among several banks and holding some amount
of physical gold for example--but those strategies were largely closed to
the poor (who couldn't scrap together enough for one bank account, let alone
two, and who didn't have a safe place to store gold even if they  could put
their hands on some).  They were also largely closed to businesses, who had
their money invested in the business, not sitting around just in case their
customers started paying late the very same week their suppliers started
demanding payment in cash.
   The key, then, to surviving a nineteenth or early twentieth century panic
was to have ample cash, to choose your bank carefully, and to have some
actual physical gold on hand.  In particular, being one of the first people
to panic--showing up to turn your banknotes into gold while the bank was
still paying in gold--was the winning strategy.  The result was bank runs
that could bring down even sound banks.
   Since there's deposit insurance to protect small and medium-sized
depositors--and since there's no gold at the bank to be gotten anyway--we do
seem to have largely eliminated bank runs, and largely eliminated the need
for ordinary people to participate even when there is one.
    Still, the solvency issues remain--if customers can't pay, even a
well-capitalized business can't continue to operate for very long.  And, as
businesses cease operations--or simply shrink to the point where they're
sized to service the fraction of their customers who can pay--employees
find themselves out on the street, facing their own solvency issues.
   And solvency issues are why, even though they're not obliged to back
deposits with gold, the banks are failing.
 
   Our new panic
   
   Even sound banks can fail in a panic, if they're obliged to pay out gold,
simply because there isn't enough gold in the system to pay off all the
banknotes at once.  Since our banks aren't obliged to pay out gold, sound
banks aren't really at risk--even if they don't have cash on hand to pay
off all their depositors, as long as they have assets (generally, loans that
are being paid back), they can get unlimited cash from the central bank.  In
this situation, what would have been a panic is merely a credit squeeze.
    So, how come banks are failing in our current panic?  Basically, a lot
of the banks aren't sound.  Their assets, instead of being mortgages on
local homes and loans to local businesses, are instead huge amounts of the
sort of "securitized" debt that you've no doubt heard about--groups of
mortgages, auto loans, credit card debts, and so on, all packaged up and
divided into slices that were supposed to have predictable risk
characteristics (but that turned out not to).
   Presumably, not all the banks are in trouble.  So, a second problem is
that nobody knows which banks are solid, which banks are iffy, and which
banks are just waiting for the coroner to sign the death certificate.
(That's why the Treasury's plan was to buy up a large amount of this
securitized debt.  The idea was, if you could put a price on those iffy
securities, the sound banks could resume normal operation.  If the price was
high enough--higher than the assets are really worth--many of the iffy
banks would be okay as well.)
    The result has been a situation a lot like a classic financial panic,
even without the issue of a shortage of physical gold.
 
   A few words about gold
   
   In panics past, the key winning strategy was to move to gold before
banknotes lost all their value.  I don't think that's a useful strategy this
time. Gold may be a winning investment, but it lacks the key attribute that
made it a winner in the past:  it isn't cash.
   Until 1933, contracts were often written in terms of gold dollars.  If
your banknote wasn't backed by gold--if your bank had closed or suspended
payment--you couldn't use it to pay your bills.  That's no longer true.  The
value of the dollar may soar or crash in terms of its international value
and it may lose its value slowly or quickly to inflation (or even gain value
due to deflation).  But you can be reasonably sure a dollar will continue to
be worth a dollar when it comes to paying your bills.  That's something
that people didn't have going for them in the panics of the nineteenth and
early twentieth centuries.
   Gold may (or may not) be a great investment, but it's a crappy way to
pay your bills.  For that, you need money--regular old bank deposits and
currency.
   The hard money folks like to say that gold is the one financial asset
that isn't someone else's liability.  In a world where many liabilities are
not being honored, that's a big deal.  But as long as your liabilities are
in dollars (or euros or pounds or krona), you want to have cash on hand to
pay your bills.  For example, I'm just three months into a one-year lease.
I know exactly how many dollars I need to pay to keep my apartment for the
next nine months.  I have no clue how much gold I'd need.
   As an aside, it seems that there actually is a shortage of physical gold.
Perhaps in part because a rather new fund (SPDR Gold Shares) has been buying
huge amounts of gold and storing it in vault--enough that its gold reserves
recently passed those of Japan.  Fabricators of gold coins  are having
trouble getting their hands on enough to meet demand.  That's a situation
that can't last for long--people will bid up the price of physical gold high
enough to draw those large gold bars out of the vaults.  That makes gold
sound pretty good as an investment--but it doesn't turn it into cash.
 
   Strategies for survival
   
   Knowing that the keys are liquidity and solvency, there are some obvious
strategies to begin with.
   Don't depend on credit.  Arrange your finances so that you can fund
everything with cash.  If you're a business, this will inevitably make you
less profitable, but less profitable is better than being out of business.
   Keep your assets safe.  Even if you avoid debt, you still have
obligations that need to be met--rent, taxes, utility bills, etc.  If your
income is uncertain (and it is), then you want to have cash on hand to meet
those obligations.  Things like bank deposits (under the insurance limits),
money market funds (now also insured), and Treasury securities are very safe
and very liquid.
   Cut expenses and diversify your income.  Having liquidity is key in the
short term, but over the medium to longer term the key is to make sure that
your expenses don't exceed your income.
   Later, buy valuable stuff cheap.  As the panic winds down, large amounts
of valuable stuff will be on sale cheap, because those who were not liquid
enough will be forced to sell.  If you've got cash at that point, you're in
a position to make some outstanding investments.
    These were the strategies for surviving panics in the past.  They're
still the strategies today.  The one good thing about a financial panic is
that it (unlike, say, a war) doesn't destroy the actual productive capacity
of the economy.  The factories are still there, workers are still there, the
land is still there.  Staying liquid, and making sure that your expenses
don't outstrip your income, will get you through to where that underlying
productive capacity can come to the fore once again.
   
 
   
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