When the Economy Really Did ‘Fall Off a Cliff’

R.A. Hettinga rah at shipwright.com
Mon Mar 23 04:44:37 PDT 2009

The elephant in the room here is that if the government was completely
excised from the financial system, the financial system would
eventually have more than enough resources to fix itself at times like
this. Or, better, prevent times like this from having their magnitude
viciously amplified by government action, at least.

It'll probably take a crash government *can't* fix to prove that
point, however, and we may be here now.



The New York Times

March 23, 2009
When the Economy Really Did Fall Off a Cliff

IN what may come to be the definitive line about our current economic
crisis, Warren Buffett said on the CNBC program Squawk Box this
month that the United States economy has fallen off a cliff.

The most trusted investor in history went on the air to talk, with
characteristic candor and humor, about the horrendous truth we pretty
much know, possibly in an effort to calm things down and point toward
some answers we dont yet know. He proceeded to give his views on what
went wrong (everybody thought house prices could go nothing but
up ... so you had $11 trillion of residential mortgage debt built on
this theory ), on peoples paralyzing fear and confusion (We are in
a very, very vicious negative feedback cycle .... I dont want this to
be the last line of the movie), and on the absolute necessity of
fixing the banks and taking clear, decisive action.

A look back at the handling of another financial crisis a full century
ago underlines the point about decisive action. You just dont want to
take the wrong decisive action. Markets today are immeasurably more
complex, global, fast-moving and regulated (a lot of good that did)
than they were a hundred years ago, but the need for strong leadership
has not changed.

In early 1906, the banker Jacob Schiff told a group of colleagues that
if the United States did not modernize its banking and currency
systems, its economy would, in effect, fall off a cliff  that the
country would have such a panic ... as will make all previous panics
look like childs play.
Yet the country failed to reform its financial institutions, and
conditions deteriorated steadily over the next 20 months. There was a
worldwide credit shortage. The American stock market crashed twice.
The young Dow Jones industrial average lost half of its value.

In October 1907, when a panic started among trust companies in New
York and terrified depositors lined up to get their money out,
Schiffs dire prediction seemed about to come true. The United States
had no Federal Reserve, the Treasury secretary did not have much
political authority, and the president, Theodore Roosevelt, was off
shooting game in Louisiana.

J. Pierpont Morgan, a 70-year-old private banker, quietly took charge
of the situation.

In the absence of a central bank, Morgan had for decades been acting
as the countrys unofficial lender of last resort, gathering reserves
and supplying capital to the markets in periods of crisis. For two
harrowing weeks in 1907, with the whole world watching, he operated
like a general, deploying three young lieutenants to do leg work and
supply him with information, and bringing two other leading bankers,
James Stillman of National City Bank and George Baker of the First
National Bank, into a senior trio to make executive decisions.
(First National and National City eventually combined to form what is
now Citigroup  are the shades of Baker and Stillman writhing over
what has become of their descendant institution?)

The Morgan teams ran stress tests on the unregulated trust
companies, figuring out which were impossibly overleveraged and should
be allowed to fail, and which were basically sound but crippled by the
panic. Once they had determined that a trust was essentially healthy,
the bankers supplied it with cash, matching their loans dollar-for-
dollar with the trusts collateral assets.

When the New York Stock Exchange nearly closed early one day in
October 1907 because financial institutions calling in loans were
choking off the markets money supply, Morgan summoned the presidents
of New Yorks major commercial banks to his office and came up with
$24 million to lend to the exchange. Next, New York City ran out of
cash to meet its payroll and interest obligations; Morgan and company
conjured up a $30 million loan and prevented default.

At the end of Week 1, President Roosevelt sent a letter to the press
congratulating the substantial businessmen who in this crisis have
acted with such wisdom and public spirit. Shipments of gold were on
the way from London to New York, and confidence had returned to the
French Bourse, owing, reported one paper, to the belief that the
strong men in American finance would succeed in their efforts to check
the spirit of the panic. During a panic, confidence is almost as good
as gold.

At the end of Week 2, Morgan called 50 presidents of trust companies
to his private library on East 36th Street, locked the doors, and did
not let them out until they had signed on to a final $25 million loan.
The scholar of Renaissance art Bernard Berenson told his patron
Isabella Stewart Gardner that Morgan should be represented as
buttressing up the tottering fabric of finance the way Giotto painted
St. Francis holding up the falling church with his shoulder.

Though Morgan had a large sense of public duty, he had not shouldered
the falling church out of pure altruism. His self-interest operated on
a national scale. His clients  many of them Europeans who had
invested for decades in the emerging American economy through the
House of Morgan  had billions of dollars committed in the United
States. In watching over their long-term interests, trying to control
the excesses of the business cycle and maintain the value of the
dollar, Morgan had come to serve as guardian of American credit in
international markets.

His power in 1907 derived not from the size of his own fortune but
from the trust placed in him by investors, other bankers and
international statesman. After Morgan died in 1913, the newspapers
reported his net worth as about $80 million  roughly $1.7 billion in
todays dollars. John D. Rockefeller, already worth a billion in 1913
dollars, is said to have read the figure, shaken his head, and
remarked, And to think he wasnt even a rich man.

Trust in Morgan was by no means universal. In 1907, some of his
critics charged that he had started the panic in order to scoop up
assets at fire-sale prices and line his own pockets. In fact, the
Morgan banks lost $21 million that year.

The difficulty today of assigning dollar values to toxic assets
makes Morgans job look easy. Yet though the amount of money required
for the 1907 bailouts is pocket change compared to the current
trillions, at the time, the troubles and the numbers seemed enormous.

No single figure, much less a private banker, could wield the kind of
power in todays gargantuan collapsing markets that Morgan had a
hundred years ago. And so far, not even the combined official powers
of the Fed and Treasury have been able to stop the cascading
disasters. Paul Volcker, the former Federal Reserve chairman, said
recently that he couldnt remember a time maybe even in the Great
Depression, when things went down quite so fast, quite so uniformly
around the world.

Perhaps new economic leadership will emerge during this crisis, under
our gifted, charismatic president. It seems likely to consist of
people who have the kind of experience, judgment and authority Morgan
had  possibly a new trio made up of the current Fed chairman, Ben
Bernanke; Paul Volcker; and Warren Buffett.

Only Mr. Bernanke is formally in a position to exercise that high
authority now, which he is doing  he announced last week that the Fed
would inject an extra $1 trillion into the financial system. Mr.
Volcker, chairman of the White House Economic Recovery Advisory Board,
could easily be promoted to a more dominant role. Mr. Buffett has
already stepped up in public, praising the steps the Fed took last
fall to insure money markets and commercial paper as vital in keeping
the place going (if the Fed hadnt acted, Mr. Buffett told his CNBC
interviewer, wed be meeting at McDonalds this morning).

Moreover, Mr. Buffett said he could guarantee that in five years or
so our great economic machine will be running a lot faster than it
is now, with the government playing an enormous role in how quickly it
recovers. Last fall he declared that we had just been through an
economic Pearl Harbor. Last week he said that in order to fight this
economic war the country has to unite behind President Obama, the
government has to deliver very, very clear messages and we all have
to focus on three jobs:

Job 1: win the economic war.

Job 2: win the economic war.

Job 3: win the economic war.

Just what Morgan would have said.

Jean Strouse is the author of Morgan: American Financier and the
director of the Cullman Center for Scholars and Writers at The New
York Public Library.

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