Economists eye history for solutions to crisis

Published Sunday, March 23, 2008

By Agencies

As the US economy stumbles, experts are looking at past crises in an effort to better understand the current predicament and find a way to avert contagion infecting the rest of the world.

Some analysts see a parallel to the Japanese economic stagnation. Others say there are signs of stagflation as in the 1970s in the United States. Even the Great Depression has some parallels, according to some scholars, while still others point to the banking panic of 1907.

"We have elements of all of these crises, and that's what makes it so scary," says Joel Naroff of Naroff Economic Advisors.

Peter Morici, economist at the University of Maryland, says the US situation most closely resembles the crisis that has left Japan in a long period of economic stagnation since a recession began in 1989.

The current US situation "represents a structural breakdown in the integrity of the banking system," Morici said.

Morici argues that the traditional banks, in an effort to generate more profits, moved beyond traditional lending to turn mortgages into securities that were packaged and sold to investors worldwide, but failed to contain the risks.

"You've got a basic structural problem in the banking system like in Japan and this is unlikely to be fixed anytime soon," Morici said.

"The banks going down is like the water is being turned off. Banks are operating at half capacity and are likely to do so until there is some reform."

Princeton University economist Paul Krugman says the danger is even greater, arguing that an economic calamity is likely if the system is not fixed.

Krugman said too much money moved out of the regulated banking and lending system to a "shadow banking network" in which savers put money in funds that bought mortgage securities "with nary a regulator in sight."

"We were partying like it was 1929 -- and now it's 1930," Krugman said in a recent blog.

"The financial crisis currently underway is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren't pulling cash out of banks to put it in their mattresses -- but they're doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction."

Krugman said Federal Reserve chairman Ben Bernanke and his colleagues "are doing all they can to end that vicious circle. We can only hope that they succeed. Otherwise, the next few years will be very unpleasant -- not another Great Depression,
hopefully, but surely the worst slump we've seen in decades."

The rise in inflation pressures at a time when growth is faltering has stirred memories of 1970s-style "stagflation" although the problems are not seen as being nearly as acute.

"I don't think we're anywhere near the situation that prevailed in the 1970s" on stagflation, Bernanke told Congress last month.

Liz Ann Sonders, economist and strategist at Charles Schwab & Co., said this is something the markets are monitoring.

"Though we're a long way from the crushing double-digit inflation of the 1970s, it's worth noting some similarities between now and then," she said.

"Then, like now, the Federal Reserve had promised to keep inflation in its sights, but reverted to an obsession over growth."

Some scholars of economic history go back even further to the banking panic of 1907, a crisis that help spur the creation of the Federal Reserve.

A century ago, it was banker J. Pierpont Morgan who brokered a deal to help bail out the banking system with the help of the US Treasury.

In 2008, it was the company JPMorgan Chase, with help from the Fed, which bought up troubled brokerage Bear Stearns, and averted a potentially catastrophic run on the banking and securities system.

Ed Kim, a financial consultant and former Merrill Lynch risk officer, says there are "striking parallels" in the crises.

"I guess we came around a full circle," Kim said.

Is history repeating itself? Some economists say the current situation is unique despite some parallels.

"I don't think the current environment fits with any historical episode," said Keith Hembre, chief economist for First American Funds.

Hembre said that unlike Japan, accounting rules in the US require banks to recognize and write off losses quickly, making it harder for bad loans to remain on the books for long periods.

Hembre said US authorities have also unleashed a vigorous response with interest rate cuts and a 168-billion-dollar economic stimulus passed by Congress.

"I think the Fed is on the case with regard to the systematic exposure that Bear Stearns would have provided," he said. Even if some banks fail, he said, he does not see a "systematic crisis" that drags down the financial sector.

Naroff argues that "it's not the Great Depression" but more closely a combination of the Japanese stagnation and the 1907 panic. He maintains that these will likely be cured by the aggressive actions of the Fed and the US government.

"We can assume we'll have another surprise, but as long as the surprise doesn't lock the system up, we may have a recession that lasts most of this year, but we'll get out of it," Naroff said. (AFP)

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