One of the most frequent questions for me this past week involved historical benchmarking: is this a regular kind of crisis, or is it a really big one? Financial crises have occurred with some regularity in history. They usually follow periods of unusual growth. The U.S. endured 13 bank panics in the 19th Century. After establishment of the U.S. Federal Reserve in 1912, the frequency fell sharply. But still, several crises involved stock market crashes and bank failures in the era of the Fed. Indeed, in the American banking industry, a small number of banks are in the process of failing at any moment in time. From a total of about 8500 banks and thrifts in the U.S., the FDIC reports 117 on its list of troubled institutions–historical experience suggests that 13 percent of these will actually fail.
When Sean Carr and I wrote The Panic of 1907, we had no premonition that a crisis would occur in 2007. But based on the historical record, we were confident that one would come sooner or later. Instability is like a latent virus in the financial system—it crops up at moments of weakness. To be a well-educated business person is to understand the recurrence of crises and to prepare accordingly for them. Financial crises are like hurricanes. Hurricanes happen annually; we understand their mechanics but predict them imperfectly and can do precious little to stop them. The whole point of public policy should be to mitigate the damage: get serious about building levees, discourage citizens from living in flood-prone areas; give plenty of advance warning; encourage evacuations, and so on.
Against this backdrop, the current financial crisis is probably a Category Five item: big and potentially very damaging. Though its self-reinforcing qualities are like other crises, this one stands out on three dimensions:
**Complexity. All financial crises depend on complexity, because it makes it hard for decision-makers to know what is going on and to coordinate rescues. Imperfect information is at the heart of crises. In the absence of good information, players in the markets will tend to panic. The current crisis tops all others in terms of complexity. First, there is the increased complexity due to exotic instruments (subprime loans, CMOs, CDOs, CDSs, Alt-As, you name it)—these are difficult to value; and some are so complicated that very few people really understand who is likely to owe what to whom. Second, there is the complexity of financial institutions. Very large institutions operate in many segments of the financial markets and generate complex financial exposure to market volatility. Managing this exposure is very difficult. Assessing this exposure as an outside investor is nearly impossible. Third is the linkage to other markets: what happens in the U.S. debt markets has implications for markets all over the globe in equities, commodities, and ultimately, to the real economy. Trouble can travel. Anticipating how problems in U.S. mortgages will radiate outward is virtually impossible today. Complexity today dwarfs the complexity faced in any previous financial crisis.
**Speed. Thanks to digital communications, trouble—in the form of news and flows of cash–can travel at the speed of light. Here are some indicators of that speed. Lehman transferred $8 billion from London to New York shortly before the firm’s bankruptcy filing on Monday. U.S. stocks immediately went into the biggest decline since 9/11/2001. Also, the market in Lehman’s commercial paper froze immediately. On Tuesday, a prominent money market fund (Reserve Primary Fund), which held some of Lehman’s paper, was forced to mark down the value of its investments and “broke the buck.” This led to a massive run on all money market funds on Wednesday, which would ultimately drain $144 billion from the funds by the end of the week. The run on the funds coincided with a flight to quality: investors plowed so much money into Treasury Bills that the three-month yield fell to zero. By Friday, the U.S. government had committed to becoming the lender of last resort in virtually all mortgage and corporate credit. That was the week that was. This kind of “fast history” is a creature of modern information technology. In 1907 and again following the crash of 1929, bad news took a little longer to strike. By the “Asian Flu” crisis of 1997, we were starting to learn the violent impact of “hot money” that can flow in and out of countries and institutions at the speed of light.
**Scale. On any measure of misery, the Crash of 1929 with the associated Great Depression is the alpha event of modern financial history. Will the current crisis come close? It is too soon to tell, since one must also gauge the possible after-effects. But already the losses in the current crisis are mind-boggling. Today’s New York Times reports that the U.S. Treasury estimates that the losses to be absorbed might reach $700 billion. With a vastly bigger economy today than in 1929, it seems possible that the current dollar ((To be fair, a comparison of crises should adjust for differences in purchasing power over time (for instance by using constant rather than current dollars) and for relative differences in the scale of the economy. My guess is that after making such adjustments, the Crash of 1929 and associated Great Depression will remain the alpha event. But all estimation should be suspended until the current crisis ends and its damage can be assessed.)) losses will grow to dwarf those of the 1930s.
All in all, this crisis is shaping up to be one of those once-in-a-lifetime events that shape the character of the generations it affects and alters the path of nations. Pay attention. What happens next is likely to leave a large impression.