An Historical Perspective on Bailouts

Ah, the Chinese Curse: May you live in interesting times.  As the credit crisis has grown, we see references back to the "forever-esteemed editor of The Economist, Walter Bagehot" (cite below) who argued that in bubbles, the central bank needed to pull back on the credit levers (rates, reserves, margin), and during the inevitable collapse go all in with assistance to keep banks solvent.  Of course, the mistake we keep making is to increase the credit leverage during the bubble, since of course the good times will continue.

The question of the moment is, do these heroic bailouts work?  I urge you to click on this link and read Bob Hoye's analysis.  Summarized below the fold, with a prediction based on history. 

Taking the British and America experience together, we have had four of these credit collapses:

• 1825-1845, driven by excessive canal building and an initial RR bubblet
• 1873-1896, the first Great Depression, driven by two RR bubbles bursting
• 1929-1949, the Greatest Depression, driven by the 2d auto bubble (first in 1915-19)
• 1998-2014 (?), driven by an Internet then a housing/commodities bubble

In 1825, the British Central Bank used "every possible means and in modes we have never adopted before" to stop the credit collapse.  Didn't work. 

Bagehot made his suggestions after the 1873 debacle, which by 1884 was being called a Great Depression.  Didn't work.   

In 1929, after the creation of the fourth US central bank, the Federal Reserve, confidence was high that we were now so much more sophisticated than those rubes back in 1873 that "nothing could go wrong."  Treasury acted fast and injected liquidity, and the Fed provided the 'classic' solution of 'free lending".  Didn't work. 

Hoye's conclusion: "Heroic efforts in the past have not reinvigorated the ultimate boom and have not prevented a severe contraction."

What happens next is some sort of deal, and much celebration.  A market bounce.  Then a deeper failure.  The heroes of the top (Greenspan and Rubin, Harrison and Mellon in 1929, etc., back to the original bubblemeister, John Law, of the 1720s South Seas Bubble), become vilified and chased as scapegoats.  Mellon was under severe legal assault in the '30s.  Whither our current Treasury Secy, Paulson? 

The prevailing system gets criticized and new ones proposed (this is already happening), and at the bottom the whole role of central banking gets revisited.  For you goldbugs, it is feasible that at the bottom we go back-to-the-future with a gold-based global currency to replace or constrain the Dollar.  Rule of alternation for central banking?   

The whole process takes a long time, much longer than people expect.  The time to workout the excess seems to be 20 years, given the last three examples.  In our case, this process probably began in 1997 or 1998 with the first set of collapses (the Asian Flu followed by the failure of LTCM), or maybe as late as 2000.  I have long thought we bottom around 2014, but this history makes that seem optimistic.  Japan is approaching 20 years from its bubble top in 1989 with no end in sight. 

Comments

[puravida19]

Regarding whether the bailout will work, the comments below speak to the allocation of the money and may help you decide whether the plan will work.

I found this comment on "the Elliotwave Lives on" link on the right - http://caldaroew.spaces.live.com/blog/cns!D2CB8C5EBA2ADE86!17492.entry

Poster is Amos
September 26 7:55 PM
(http://cid-3789a6c8165382a4.spaces.live.com/)

The plan from the Bushies helps stricly no one beyond providing TEMPORARY relief to banks, which might be enough but does not quite explain their willingness to engage in such brinkmanship.

Which makes the following suggestion, emailed to me by a US central banker friend, all the more intriguing:

Jerome,

I've been puzzling why Paulson would propose legislation which is so obviously dictatorial, extra-legal and dangerous, even with the careful orchestration of the Lehman Brothers/Reichstag Fire.

I think I've just figured out why they are doing it.

All the Fed's alphabet soup of emergency liquidity facilities innovated over the past year were structured around repurchase agreements. Toxic waste securities were used as collateral for US Treasuries and dollar credit at 85 percent of face value. But as each facility expires, it has to be rolled over and increased to keep pace with the implosion of credit in the interbank markets. Well over half the balance sheet assets of the Fed have been loaned out in this way, perhaps a critical amount in excess of this estimate. Without recapitalisation, the Fed is at risk of failure in the midst of this crisis. Its Enron-style accounting for the toxic waste makes it very vulnerable to a default by any of the repo counterparties it oversees and limits its ability to enforce any constraints as well.

The Paulson plan will provide a one off opportunity for banks to take their toxic collateral back and sell it at a Paulson-determined price for cash. He issues Treasuries to finance the plan which increases the supply available. He selectively decides winners and losers, of course in making the scheme available and pricing assets, creating arbitrage opportunities and survivor bias in the process.

In the meanwhile, the removal of the toxic waste from the Fed balance sheet and redeposit of Treasuries and cash as the repos unwind gets the Fed off the hook for having hypothecated most of its assets against worthless toxic waste at Enron-styled false valuations.

If I'm right, the Paulson Plan recapitalises the Fed without ever publicly admitting that it was dangerously overextended.

My friend provides this video which says Fed has lent out $600 billion of its $800 billion balance sheet.

http://video.msn.com/video.aspx?mkt=en-US&brand=money&vid=25f132d8-4c5d-4f8d-96ca-2d9f327396e7

and concludes a follows:

Real question in my mind is whether the $1 trillion from the Paulson Plan goes to recapitalise the Fed as I suggest, or whether it goes into offshore flight capital before the criminal mafia in Washington and Wall Street flees the jurisdiction.

The theory here is that the Fed has destroyed its balance sheet by taking on increasingly large chunks of non performing assets (the "toxic waste" made from mortgage-backed securities and the like) in exchange for loans of "real" cash to banks that may still end up not repaying them.

It is effectively "broke." This is not what is supposed to happen to a central bank, which can print money without restriction, so let me explain what this means: it can no longer help the banks in a non-inflationary way. In order to take on more toxic collateral from the banks, it would need to actually print money, which would immediately be visible and would be seen as very inflationary. Instead, by getting government to take on more public debt, the impact is diluted in a much larger pool (public debt, rather than cash).

So this is a desperate gamble by Paulson and Bernanke to avoid the run on the dollar that would be triggered by direct cash creation.

Obviously, as the market shows (with the euro up by 6 cents since the plan was announced Thursday night, and gold and oil similarly massively up), worries about inflation have not quite been killed, but they have been kept to a manageable scale.

At this point, of course, the goal is to avoid a bigger crash before the election.

end

[Sean]

CS Trading,

MayDay Mayday! CS do you still see treasury yields going down much further? The fundamentals and the actions in the last week showed that the bonds may have topped and going down big time.

What's your take? Thanks!

[VirginiaJim]

Bailout. Originally 3 pages became more than 130 before House Republicans walked. Included not only $700B to buy bad paper but another $650B of pork. Rumor is some pork was removed but a lot remains including money for ACORN (Obama's 'community organizer' employer that is indicted for systemic voter fraud) and a reach back mechanism where judges change private mortgage contracts at will. Interesting, a proposal by a White House that had repeatedly warned about FNMA/FRE and derivatives, championed by a party that party line opposed regulation of FNMA/FRE and took millions of money from FNMA/FRE.
http://www.youtube.com/watch?v=H5tZc8oH--o

[Howard Bernstein]

JP Morgan was able to stop the Panic of 1907 by letting the bad banks fail and buying the assets of the good banks. That marked the bottom in the stock market in Nov 1907 and the market was back at new highs in less than two years.
Dow chart from 100 years ago:
http://64.233.169.104/search?q=cache:p-mH8Mzzr_4J:averages.dowjones.com/mdsidx/index.cfm%3Fevent%3DshowavgDecades%26decade%3D1895+dow+jones+prices+1907&hl=en&ct=clnk&cd=1&gl=us

[deacon]

'boom gloom and doom' marc faber now realizes commodites will drop and the us dollar is the place to be!
(http://www.bloomberg.com/avp/avp.htm?N=av&T=Marc%20Faber%20Says%20U.S.%20Credit%20Losses%20May%20Total%20%245%20Trillion&clipSRC=mms://media2.bloomberg.com/cache/v17547EBDGvY.asf)
...last session of month thru 3rd session of new month as bullish as it ever gets for SPX due to window dressing and 401k type monthly inflows...
could be a bad week for commodities, funds should window dress out of commodities to end 3rd quarter, and the index funds that make decisions to open a quarter should also sell...corn still has 340,000 index fund longs with the republican position to eliminate the ethanol mandate including the brazil ethanol tariff
...in a worldwide recession commodities deflate and money will go to the safest currency there is, could even be a worldwide depression if the bernanke/paulson bailout stick saves don't work

[MHD]

Yelnick....how are you going to get your "surge" if the bailout doesn't work? If credit doesn't ease then Bob's P. view of a deflationary spiral is looking real good, and I don't see a tech surge in that case.

[Canadian Money]

Its not crystal clear to me how they intented to use this money but $700 billion may not go very far in any attempt to control the stock market.

Some examples:
Apple Computer, trading near $110 per share and 1 million shares or more changing hands each day. That comes to 110 million dollars per day.

Home Depot, trading 20,000,000 shares per day at $26. Another $500 million per day.

Potash Corp of Sask. (POT.TO). An important stock on the Canadian TSX Index.
$140 per share with about 1.5 million shares trading per day. Another $200 million each day changing hands.

These numbers suggest to me that even the US Government cannot afford to manipulate the stock market for more than a very short period of time.

[min]

That's enough for me. I feel like such a pig. Closing my NDX short for a 500% gain. Going long with tight stop.

[Ramsey]

The SURGE is here!!!
FOLKS The Surge is here

The surge, the surge, the surge....

[Ramsey]

Escuse me above post made a mistake....surge is not here...

Here comes the depression. with money tight expect it to be deflationary. Break out the campange at Precter Residence.

Expect gold to fall eventually with every assest class, commodities are already being hit.

Many banks will be toast in the next month.

They banned short sellers

They might as well bank selling of shares and finish the job.

[MHD]

Good idea....ban selling of any bank stocks. Why didn't I think of that. :-)

[Min]

You guys had it right the first time. A surge (at least a mini surge anyway) is coming. For now decline is mostly done. It was a helluva profitable ride down though.

Re-entering long NDX.

[cribrange]

Last time I spoke, I suggested simplicity was the way forward and the Elliott wave structure on the Nasdaq 100 suggested an acceleration down to 1480 cash which has more or less been reached. This so called liquidity index from Yves has been quite atrocious recently and the embedded optimism inside the "Major Buy Signal" post written on the 15th September is disappointing. We have lost 12.5% since that call and no stop loss was provided. I consider therefore that Yves is still long at -12.5% and no matter how you structure your money management, that is going to hurt you. Your only chance now is that the market holds above this support and rallies hard and then you come out victorious, but with a -12.5% interim drawdown, I sincerely hope you have the brains not to beat your chest. On the flip side, if 1480 fails to hold, then we will be staring down the barrel of 1265 and even 1130 points. If that were to happen and you have not amended your long recommendation, I will add you to the list that currently has just one member, the Dow Predator (who is also still probably long). Apologies if this sounds harsh, but it is the complete lack of risk control that I despise here, more than the wrong direction.

Cribrange

[ramsey]

Quite right Cribrange!! I despise this too. Those with complete lack of risk control should be taken to task.
If advice is not given in the yelnick blog these suckers will go down in a big way.
Funny how the Dow Predator has now become the hunted.. and is probably on the run.

[Harold]

There was a flurry of posts here a few weeks ago and, considering the market action, I'm suprised it's so relatively quiet.

An exuberant mood is sufficient to pull us out. A neutral mood is going to be trumped by margin calls and we'll keep going down. A fearful mood and we'll go down faster.

So, unless exuberance returns, the only thing that will keep the numbers high is the printing press. How will the money be disseminated? I don't know. How can you do it stealthily in a democracy?

It might be that we crash hard and very quickly. Down 50% in a day or two and then --boom-- major stagflation. All the price increases are on food and fuel.

[dlu]

Yelnick,
Two people have been caught offgaurd Neely
on gold and Yves on stocks. the third is no more being discussed on this site. TonyC. his primary wave B call was proved wrong.
this round goes to BobP.

[Paul]

Yeah, that was a bad call by Yves. But his reasoning for that call was even more idiotic.

[yelnick]

MDH, the Surge will be the 9-12 month rally from pretty soon to May-ish 2009. Pretty soon would be after a fast washout down (this week?) with perhaps a few weeks of bouncing a bit before a triple bottom and a real rebound - the Election Rally. The deflation of Prechter looks likely, although the measurement of it won't be immediate - similar to inflation usually showing up 18-24 months after excess money growth.