Arnold Kling  

A Historical Anecdote

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Monetary Theory and Policy... The Power of Mistaken Identity...

From Supermoney, by 'Adam Smith' (George Goodman), p. 31 - 49:


In a Crunch, the country runs very dry of money...

Everybody could tell, that June weekend in 1970, that a Crunch was on: it was difficult for borrowers to breathe, and their ribs hurt...
The liquidity crisis of that time didn't have much to do with the inability of buyers and sellers of stock to find each other and touch fingertips. Liquidity in this case meant usable funds, borrowable funds for American business...
By June of 1970 the sixth largest enterprise in the United States and the largest railroad in the country, the Penn Central, was busted...It was having trouble renewing, or rolling over, its maturing commercial paper...
Penn Central's lawyers began to draw up the bankruptcy papers...it did not have to pay its debts, except under reorganization...it would not pay the holders of its IOU's, its commercial paper. They could paper their bathrooms with all $200 million...
The worriers began to see the following script: the holders of the Penn Central's commercial paper would be busy papering the bathroom and calling their lawyers...investors would not exactly be reaching for more commercial paper. The commercial paper from other companies had short maturity: some would come up Monday, some Tuesday, and so on.
There was $40 billion of commercial paper outstanding...where would $40 billion come from as the notes matured, day by day?...
But there is a lender of last resort; that is why we have a Federal Reserve system...a Fed governor was to worry about Monday morning, and to treat the weekend as something special in history. The issuers of commercial paper would not be able to sell any more; they would go to their banks; the banks would say, sorry...the issuers would start to lay off people and cut back operations; everybody could stake out a corner for an apple stand, if the corner wasn't already occupied by a fried-chicken stand. The notes of a Fed official to a Fed meeting later that summer uses this language: "inability of the issuers to pay their paper at maturity would have dire consequences for issuers, the commercial paper market, other financial markets, and the banking system." Dire consequences is a phrase not used lightly...
[Acting President of the New York Fed William] Treiber got on the phone...He called the head of every major bank in New York at home...By Monday night, phone calls had gone out through the twelve Federal Reserve banks to every bank in the system--not just to big city banks, but to small-town banks all over the country. The Fed's index finger was beginning to bleed from all the dialing. The message was the same: if anybody comes into your bank and wants a loan, give it to him.
I love the writing--I recommend picking up used copies of both Supermoney and The Money Game. As dated as the anecdotes are today, they still are entertaining.

And, of course, the weekend activity with Bear Stearns, which reminded me of the anecdote quoted above, tells us that some things are timeless. In 1970, the Fed kept the Penn Central bankruptcy from spilling over. Keep your fingers crossed that they can be as successful in 2008.


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COMMENTS (3 to date)
Buzzcut writes:

What do you have against the Library?

My crappy library system is very good for having outdated books. Not much else, though (no "Crisis of Abundance", for example).

fundamentalist writes:

The Feds always bail out the guys behaving badly, then turn around and dump a boat load of new regulations on the good guys. Does anyone besides me see this as rewarding bad behavior and punishing good? It's just like in 5th grade when the teacher kept the entire class inside during recess because three boys misbehaved.

ram writes:

It seems the Fed was wiser in 1970.

It recognized a problem, a contagion effect leading up to the drying up of credit, and attacked that directly while letting the culprit go down. That is, the bankruptcy was not the problem, but the contagion effect was.

In 2008, it's taken a twisted route to... What? It essentially "bought" some terrible paper from BS, transferring the risk, at the very least, to taxpayers, and then letting JP Morgan take the better parts at almost-zero price. Not too different from nationalizing BS, keeping the nasty bits, and giving out for (almost) free the good parts. At least the UK is keeping both the good and bad of Northern Rock.

What I'm trying to say is that if buying the bad paper was the only way to stop contagion from BS dropping it in illiquid markets at basement-sale prices, why not keep the good assets too as better collateral for the taxpayer?

(And moral hazard might have been contained by the $2/stock purchase price, but $2 is infinitely more than $0.)

In the end, sentiment was not relieved, but turned rather panicky. If anything, it's Lehman's and Goldman's reports that have helped calm things down.

I'll keep my fingers crossed that the Fed proves successful again this time round, of course! But my rational bets, given the evidence of its actions so far, are somewhere else.

(Call it insurance: this way, I get some relief either way!)

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