Resisting the overwhelming urge to panic

Over the recent holidays I finally managed to watch most of the 7-part Ken Burns series about World War II on PBS that I'd long saved on Tivo. One of the common threads of "The War" was that the U.S. was ill-prepared for war after the bombing of Pearl Harbor, but the stories of the individuals profiled in the documentary usually show enormous courage and the constant struggle to fight the urge to panic. If you want to get a better sense of "The Greatest Generation" and their struggles in this war, I highly recommend "The War" as a type of history lesson unlikely to be found in a textbook.

I mention this because there's a story in the Wall Street Journal which references the book "Manias, Panics and Crashes" (published in 2005) and claims since we're now in the "Panic" stage for housing and finance that rational minds will be required to avoid further disaster.

First, how we got here:

Amid the daily market turmoil, and to help prevent a crash, it helps to step back and remember how we got here. With the benefit of hindsight, everyone can see that the U.S. economy built up an enormous credit bubble that has now popped. Our own view -- which we warned about going back to 2003 -- is that this bubble was created principally by a Federal Reserve that kept real interest rates too low for too long.

In doing so the Fed created a subsidy for debt and a commodity price spike. The price spike contributed to "excess savings" in countries with a low propensity to consume and which channeled that money back to the U.S. That capital flow and debt subsidy, in turn, became fuel for smart people in mortgage companies, investment banks and elsewhere to exploit. In a sense they created a new financial system -- subprime loans, SIVs, CDOs, etc. -- that is enormously efficient and brought capital to new places. But thanks to low interest rates and human enthusiasm, this debt spree also got carried away. This was the mania phase...

This does not mean that this decade's growth has been illusionary, any more than the 2000 bursting of the dot-com bubble means growth in the 1990s was fake. Enormous wealth was created in both periods, new industries have developed, and in the current decade there has been a genuine global boom. The excesses have been based mainly in housing and finance, and that is what now threatens the larger economy.

Next, our current situation:

Enter the panic stage. The desire for debt has turned into a stampede to quality, especially Treasury bills. The same folks who never predicted the economy would recover in 2003 are now cheerleading recession. Any bank writedown or deal to raise capital -- no matter that it is part of the healing process -- is taken as a sign that there is more bad news to come.

Meanwhile, the politicians plot to "stimulate" the economy by dropping dollars from the Capitol dome. We are also told the Fed funds rate must chase the 90-day T-bill rate down to the levels it reached when we had negative real interest rates -- never mind the anemic dollar and soaring commodity prices. The danger now is that this panic becomes a self-fulfilling prophesy and talks us into a crash.

There are two ways in which a crash could happen. The first is insolvency of one or more financial institutions that triggers a systemic failure. The second is a loss of global confidence in U.S. financial management and the dollar. Neither has to happen...

Finally, some solutions:

We are only in the early stages of this repair operation, and no doubt some companies will fail. The task for regulators is to avoid surprises that cause more panic and above all to prevent systemic contagion. Warren Buffett's recent entry into the troubled bond insurance market is another sign of the marketplace helping to heal itself. In cases where there is real systemic risk, the government through the Federal Deposit Insurance Corporation may have to rescue some institutions. In those cases, the equity holders need to be zeroed out and the management replaced. The overriding goal is to keep the banking system functioning.

As for the other crash scenario, we wish the Fed hadn't squandered so much credibility this decade. Then it might be better placed to reduce interest rates as fast and as far as Wall Street and Donald Trump are demanding. But with prices rising and the dollar as weak as it's been since the 1970s, the Fed has less room to maneuver.