Long ago in a Galaxy far, far away . . . I'm not going to go that far but you know I like my historical context. I am going to talk about the current economic situation, call it the COVID-19 Panic. But first, as advertised, some background.
In the middle ages most people lived on farms that existed within the domain of the local feudal lord. There was no money to speak of and what passed for government was provided by the lord. He provided for the common defense, maintained the roads, and provided a few other basic services. He levied a tax that consisted of some portion, traditionally a tenth, of whatever the farmer produced in return. The important thing was that all economic activity was local.
In the few larger cities and towns Goldsmiths and Silversmiths started providing a service to the rich and powerful. They would store their valuables in a safe or strong room. Using this shared resource cut down on costs. And the smarter of them observed that only a few people needed their valuables at any one time. So they could make a tidy buck on the side by loaning out some of the stored valuables at interest. This was the beginning of the banking system.
And it eventually occurred to the rich and powerful and those that they did business with that there was a better way to do so than using the valuables themselves, the plate silver, coins, etc. Instead, a piece of paper called a "draft" could be used. The draft promised that "valuables in an amount equal to whatever" would be handed over to the bearer ""on demand".
These "demand drafts" were was the foundation of currency. And this new and improved way of doing business quickly became very popular. As a result, some "banks" (places where you "banked" your valuables) got so big and successful that they were eventually able to finance the governments of whole countries.
A country like France would issue a certain amount of "coin of the realm". But for really big transactions, ones involving more than a bag or two of coins, they came to depend on demand drafts drawn against banks run by the Rothchild family, for instance.
The Rothchild's were one of the first to go international. Various family members set up banks in various large cities in various countries. Money in large amounts could be moved from place to place by using a demand draft drawn on a Rothchild bank at one location. It would be honored by Rothchild banks operating at other locations, perhaps even at a location located in another country. This became common practice in Europe.
The US ended up with something similar but less well developed. Various government sponsored "national" banks were created. But politics did them in. So, for a big chunk of the history of the US, there were only small banks that confined their operations to relatively small geographic areas.
And for the most part that worked fine. Most people traveled no great distance. And the advantage of paper money were so obvious that for a long time it was the custom of each bank to issue its own currency. It was not only the done thing but it was completely legal at the time.
At this time the Federal government was tiny. Like the feudal lord of yore it provided only modest services. It provided for the national defense, maintained some roads, ran a postal service over those roads, and that was pretty much it. Almost all revenue came from tariffs assessed on imported goods. The Federal government had little or no daily impact on most people most of the time.
But then railroads and the Civil War came along. Railroads were the first large business that operated on a national scale in the US. They needed a banking system that was national in scope and big enough to serve their needs, which dwarfed anything that had come before. Sadly, there was nothing in place to meet these needs.
The Civil War was an enterprise whose scale dwarfed even the largest railroads. Soon after the start of the War the Union government was raising and spending unbelievable sums of money. The Confederate government was smaller but it too was soon operating on a hitherto unheard of scale.
The War cost more than a million dollars a day to prosecute. That was sum far beyond the capabilities of the then extant banking system. As a result, the US government, which had previously confined itself to minting coin, got into the business of printing paper money, called "greenbacks" for the color of ink used then and now.
All this was grafted on top of a wholly inadequate system. And banks were still issuing currency backed only by their good name and reputation. Back in the time before the War and before the railroads, this business of each bank issuing its own currency worked, sort of.
Local people knew their local banker. If they spotted something hinky, the thinking went, they could pull their money out before the bank went under. Only suckers (people who lived some distance away) would get hurt when that bank's currency became worthless.
But after the Civil War got under way that became impractical. And soon there was fantastic amounts of money sloshing around as the railroads, then the oil industry, the steel industry, etc. became giants. As a result, we had a "panic" (that's what they were called) about every ten years.
If a small bank here or a small bank there all of a sudden went under it was hard on the locals but had no wider impact. But after the War ended various developments like the railroads operating on a national scale knitted banks together. So you now had the possibility of a serious ripple effect.
One bank going down could cause a run on another bank and the situation could now spiral into an event that had a broad impact. It didn't happen every time. But it happened often enough, about once every ten years, on average.
Finally, in 1914 the Federal Reserve was chartered. The thing that allowed it to survive political challenges that had taken down it's predecessors was it's "economic stability" mission. It was supposed to stop these very destructive panics from happening.
It was not completely successful. Banks could still go under and people could still lose their money. The possibility of a panic was enough to cause people to start a "run on the banks". Panics happened often enough that people were all too familiar with them.
Bankers of the time had the same problem that their Rothchild era predecessors had. Everything was fine as long as everybody didn't try to pull their money out at the same time. (And assuming the banker wasn't an outright crook or completely incompetent.)
A run didn't require everybody to demand their money. It only took a significant portion of depositors demanding their money, all at the same time. That was enough to turn a sound bank into an unsound bank.
What finally fixed the problem was the introduction of a government agency called the FDIC in the '30s. It guaranteed that people would get their money even if the bank went under. Once the Fed and the FDIC were in place we went a long time without anything that looked like a panic. People and companies could go about their business without worrying about whether or not the bank they used in was in danger of going under.
But this Fed/FDIC solution eventually became a victim of its own success. The fact that nothing had gone wrong for a long time caused people to forget what a panic looked like. That amnesia gave political factions the opportunity to weaken the system so they did. So we went back to a point where panics became possible again. And with that, I would like to look at some panics. And I am going to start with the big one, the Great Depression.
We all know that the Stock Market crashed in 1929. But at the time the Market was not that big of a thing. Only a few rich people owned stocks. And the fact that a company's share price had tanked had little or no effect on the day to day operation of that company. But important people were harmed by the Crash and they forced the Federal Government to take action.
It was not the crash itself but the response to the crash that did most of the harm. Under Hoover the Federal Government's response was to do what everybody thought at the time was the right thing to do. That was to clamp down on the banking system. Bank reserves must be increased. Loans must only be made to blue chip clients. Unlike with the crash itself, these changes had a widespread impact.
Many businesses both large and small needed access to credit. All of a sudden only the people who didn't need credit could get credit. That caused businesses large and small to pull back. They started cutting back on production and laying people off. That meant business dried up for suppliers who responded by laying people off. Laid off people (there was no unemployment insurance at the time) were forced to cut back on their expenses so they bought less. And the spiral continued.
In the mean time, banks had less money to loan because they had to hold more back to meet the higher reserve requirements. And at the hint of any weakness on the part of any bank customers started a run on that bank. If the bank had been sound before it soon wasn't. That spawned even more runs as people and businesses got more and more concerned about losing money they couldn't afford to lose by keeping it an a bank that might fail.
The Hoover Administration kept tightening and tightening. And things kept getting worse and worse. That ushered in the Roosevelt Administration. They put in the FDIC and mandated a "bank holiday", temporarily closing all banks. During the holiday every single bank still in existence was audited. Some banks were found to be unsound and they were closed. But most banks were found to be sound.
Once the holiday was over and a bank opened back up its customers were told that it was "backed by the full faith and credit of the Federal Government". People believed the promise, which was kept then, and is kept now. Bank runs became a thing of the past. That didn't fix the economy but it did fix the banking system.
The next time there was a significant problem in the banking system took place roughly fifty years later. It is usually called the S&L Scandal. But I'm going to call it the S&L Panic. It turns out that "there are banks and then there are banks". (Unfortunately, I will need to return to this later.)
The FDIC promise that a "bank" was backed by the full faith and credit of the Federal Government applied only to "Federally chartered commercial banks". What? If a bank has the phrase "National Bank" in it's name then it's covered by the FDIC. But there are other kinds of what most people think of as a "bank". The two biggest groups of these other types of "banks" are "Savings and Loans" and "Mutual Savings Banks".
There are technical differences between the two. But for our purposes we can ignore these differences and lump them together. Both were considered to be "community banks". They dealt with consumers by offering car loans, mortgage loans, and the like. They also took deposits. But they couldn't provide standard checking accounts. Nor could they make loans to businesses.
The limits on the types of activities they could engage in was supposed to make them smaller, less risky operations. So they didn't require the intrusive business standards and audit requirements that the FDIC imposed on Federally chartered commercial banks. (It turns out that there are also state chartered banks but I am going to ignore them.)
They were not part of the FDIC insurance and regulatory system. Instead, they had their own insurance system and regulatory agency. But both were not anywhere near the industrial strength operation the FDIC was. The thinking was that they didn't need to be.
Anyhow, the people who ran the S&Ls and MSBs agitated to give these institutions more bank-like capabilities. In the deregulatory era of the time, they got their wish. They could provide checking accounts, their ability to make loans was greatly expanded, and so on. They could have been folded into the FDIC system. But they liked the looser regulatory environment and lower cost of insurance they were used to. They managed to keep it.
And the hotdogs that had been behind the change behaved like hotdogs. And promptly got into trouble. There were lots of crooks who did crooked things. There were lots of incompetents who did incompetent things. As a result lots of these institutions got into lots of trouble.
And the FDIC-lite insurance system they were using wasn't up to the task of covering their losses. Nor was the FDIC-lite regulatory agency they reported to able to keep them in line. So naturally they applied to the Federal Government to bail them out. And they got their wish.
This cost taxpayers tens of billions of dollars. In the end the remaining institutions were theoretically on a similar sound footing as the FDIC insured national banks. The bad news was that it wasn't really true. The good news is that a lot of people went to jail. Not enough, but still some is better than none.
This "put them on a sound footing" business was true to some extent. But a lot of it was a sham. They still had their own FDIC-lite regulatory agency. It was beefed up but still that wasn't nearly as stringent as the FDIC. And the insurance requirements were improved but remained FDIC-lite too. But people pretended that the problem was solved and moved on. And for a long time nothing happened to contradict this happy picture.
Next in line is what I call the Dot Com Panic of 2001. I have a low opinion of the movers and shakers on Wall Street. So, when things go wrong, my first instinct is to blame them. But this is one of those rare examples where it was not their fault. The general public did this mostly on its own. They got little or no help from the usual cast of Wall Street slime balls.
The IBM PC was introduced in 1981. It was not the first PC but it made a very big splash when it arrived on the scene. And the fact that it came from IBM, then a giant and well respected company, legitimized the whole thing.
And it turned out that it didn't take much time for smaller, smarter, and more nimble companies to figure out how to cash in. Microsoft was one of the first. They got in bed with IBM. That's usually a recipe for getting swallowed whole. But Bill Gates outsmarted IBM and emerged on top.
Compaq Computer, then (and unfortunately also now) a company nobody had ever heard of, pioneered the process of legally cloning the IBM PC. The result was a "compatible" computer that would run all the IBM software but which cost significantly less.
Compaq (and the other clone companies that followed in its footsteps) made a ton of money. With it now established that "there's money in them there computers" lots of companies started piling in. And for a long time personal computers (and later the internet) looked like a license to print money.
Both Microsoft and Compaq were financially sound companies. But then we started seeing companies who said "trust me -- we'll eventually make a ton of money". The public bought the argument and bought the stock. So the share price of these stocks went up and up and up.
At first Wall Street steered clear. They just couldn't figure out how these companies could make enough money to justify their share price. In many cases, Wall Street couldn't figure out how many of these companies could ever make any money at all. But the public ignored the advice of Wall Street and bought the stock anyhow. People made a whole lot of money in a very short amount of time.
Wall Street did eventually climb on the band wagon. But they never went all in. And they certainly weren't driving this particular train. And it turned out that Wall Street was right. Many of these companies never made any money. Others made some money but not nearly enough to justify their share price.
And eventually the public caught up with Wall Street and started selling. And prices went from the stratosphere to the cellar almost instantly. But by this time these "dot com" companies made up a big chunk of the Market. So when they went down the market as a whole went down. People who invested aggressively in these stocks lost 90% of their money. Conservative investors like myself lost 20-30%.
This shook up Wall Street. And individuals who had invested heavily lost heavily. The Dot Com Panic depressed the Market in particular and the economy as a whole in general. By this time most people had some money in the Market. Often it was in a company sponsored 401-k. So the pain was widespread. But for most people (and for Wall Street) the pain was modest and short lived. I got all my money back and more within a couple of years.
And that leads me to the "Panic of '08". This was a typical panic in that Wall Street had its greasy fingers all over it. In spite of the fact that taxpayers had ended up ponying up tens of billions of dollars as a result of the S&L Panic, the pressure for deregulation continued. In fact, it probably increased.
In the run up to the Panic of '08 the patchwork of regulatory agencies, audit requirements, reserve requirements, etc. that had built up around "banks" had not been fixed. Bank-like institutions were allowed to pick their regulator. Not surprisingly, they tended to pick the one that regulated the least.
And it turns out (as I warned you above) that there is yet another kind of "bank". Nationally chartered and FDIC insured banks are called "Commercial Banks". They do business with ordinary people and all kinds of companies.
But there is another kind of bank called an "Investment Bank". They are children of Wall Street and, the story goes, they only deal with sophisticated customers who have considerable expertise in investments, banking, risk, etc. So Investment Banks neither need nor want to be subjected to FDIC regulation. This argument worked. They were not subject to FDIC oversight.
And for a long time this seemed appropriate. If an Investment Bank got into trouble then the only people who would suffer a loss were sophisticated Wall Street types. There was even a law in place to force this. But Glass-Steagall, as the law was commonly called, was repealed in 1999. It had said that a bank can be a Commercial Bank or it can be an Investment Bank but it can't be both.
For a long time Investment Banks had been very profitable, far more profitable than Commercial Banks. But as banking laws changed over time it eventually became possible for Commercial Banks to grow quite large and to diversify into many lines of business. They saw owning an Investment Bank as a wonderful business opportunity and as the next obvious diversification step.
And by this time some "little" Mutual Savings Banks (the cousin of a Savings and Loan) had gotten quite big. At one point Washington Mutual, a Mutual Savings Bank that started in my home town and was still headquartered there, was the fourth largest "bank" in the US. WaMu, as it was called locally, had aggressively shopped for a regulator that was completely unprepared to handle an institution of its size and complexity. That made it easy to fly under the radar.
And lots of companies were flying under the radar. They structured their operations so as to avoid all but the most minimal regulatory and audit requirements. Then they started writing mortgages that were highly unsound. I'm going to skip over the details. (If you want more on the subject, it can be found here: http://sigma5.blogspot.com/2013/04/speculative-bubbles-part-2-of-2.html). But wait, there's more.
Wall Street thought these unsound mortgages represented a great opportunity. They packaged them up in such a way that they looked like "AAA" super-safe investments and started peddling them to one and all. Who wouldn't want a super-safe investment that paid a high rate of return? So they had no trouble selling all they could manufacture.
Eventually reality caught up with the unsound mortgages. A lot of regular people lost their homes. And, after a short delay, these so called super-safe investments started going bad. And they took the people who had invested in them down with them.
And the people who had been front and center on all of this had been the Investment Banks. So they started going down. Investment Banks going down was only supposed to hurt sophisticated Wall Street types. But by now it was all tied together. So the Commercial Banks were soon in big trouble.
The result was the TARP, the Troubled Asset Recovery Program. TARP bailed out Wall Street and the banking system. Since we all use the banking system and most of us have at least some money in Wall Street this was good.
But none of the people who lost their homes or were laid off as business took a dive were bailed out. And nobody went to jail even though there was widespread lawbreaking. WaMu went from being the fourth largest bank in the country to being the largest US bank to ever to go bankrupt.
Wall Street came back. And it didn't take all that long. I suppose that, given the amount of money the Federal Government poured into them, that's not very surprising. And, after a long hard slog lasting roughly a decade, main street had finally pretty much recovered when COVAD-19 showed up.
To be fair, the COVAD-19 Panic we are now in, is another of those "not Wall Street's fault" panics. Wall Street is having just as much trouble as everybody else in trying to cope with it. We've all been forced to become COVAD-19 experts. Social distancing, stay-at-home orders, and closing down "non-essential" businesses strikes at the heart of the economy. And a lot of people are getting very sick. This too sucks up a tremendous amount of resource.
Given all this, what's is the economic lookout? The short term answer is easy: It will be devastating. As I write this ten million people have filed for unemployment in just two weeks. A lot of the country, including the part I live in, has been locked down for weeks. The rest of the country will soon be locked down. While that's going on the economy will head straight into the toilet. And it will stay there as long as the lockdown continues.
Sharp economic shocks, if they are of short duration, can produce swift rebounds, a so called "V" curve. The Pollyanna's among us are hoping this is what's going to happen with respect to the COVAD-19 Panic. But from an economic perspective (and from many other perspectives too) this is an unprecedented event. It is not like any of the other Panics I have discussed. So they don't really provide much in the way of guidance.
The event that is most similar to is one I haven't discussed. A "Spanish Flu" Pandemic swept the world in 1918 and 1919. Broadly speaking, COVAD-19 is a Flu. So was the Spanish Flu, named because it was first identified in Spain. It didn't start there, but by the time scientists figured that out, the name had stuck.
The Spanish Flu panic is inextricably connected to World War I. It started just as that War was winding down. And the devastation and unsanitary conditions that were part and parcel of the War helped get it firmly established. Like COVAD-19, the Spanish Flu was almost impossible to stop once it got established. Like COVAD-19 it swept across the world. It would pop up here then pop up there.
There are differences in behavior between COVAD-19 and the Spanish Flu. But they are unimportant with respect to our discussion. A lot of people got sick. A lot of people died. Medical infrastructure got overwhelmed.
Of course, back then the medical infrastructure was not as sophisticated as it is now. For instance, the ventilator had not even been invented yet. But what they did have was the ability to manufacture cheapo masks in large quantities. So they did.
There are pictures of people out in the streets of Seattle at the time. Everybody was wearing masks. It was the law. Of course, back then you could get masks in Seattle and pretty much anyplace else in the world.
With all of our modern sophistication cheapo masks are now a single source item. They all now come from China. China was hit hard and hit first by COVAD-19. This put a dent in their ability to manufacture things. But they are now in the process of restarting their manufacturing sector. And they made zillions of cheapo masks for domestic use as part of their strategy for combatting COVAD-19.
The problem we in the US have is that there is a trade war going on between us and China. This makes it hard to import the tens of millions of cheapo masks we would need to make a mandatory "mask while you are in public" order practical. So such an order has not been issued.
People have stepped in with homemade cloth masks. They are better than nothing but they are not even as good as the standard cheapo mask. And you need a much fancier N-95 mask for the mask to provide a serious level of protection.
The Spanish Flu definitely depressed the economy. How much? We don't really know. The end of World War I also depressed the economy. How much should be attributed to one versus the other is something nobody knows. But it looks like even if we attribute all of the economic damage to Spanish Flu and none of it to World War I, the economic impact of the COVAD-19 Panic will be much larger.
How much larger? We don't know. The US response has been disorganized and confused. And this applies to both the medical side and the economic side. There things both medical and economic that can still be done to reduce the damage and to bring the COVAD-19 panic to an end more quickly. So far this is not being done. And we don't know when that will change.
People have been studying epidemics and pandemics as a medical problem for a long time. If you can give the experts a few key numbers they can tell you how severe things will get and how the medical part will play out over time.
We have been measuring these numbers. The best you can say so far is that results are mixed. Some places are taking the appropriate actions. But lots of other places aren't. It is barely possible to close international borders so we aren't harmed by bad behavior elsewhere. But that can't be done in the case of state and regional borders. Besides, judging by current statistics, we are one of the places engaging in bad behavior.
The obvious thing to do is to institute national measures to mandate good behavior. That hasn't happened. Unfortunately, it may never happen. What's stopping us is not medical or economic considerations. It's political considerations. And that makes COVAD-19 a political problem before anything else. I wish it were otherwise.
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