Wall Street Fears for Next Great Depression

[David Farber <dave () farber net>]

Begin forwarded message:
From: dewayne () warpspeed com (Dewayne Hendricks)
Date: March 17, 2008 9:00:12 AM EDT
To: Dewayne-Net Technology List <xyzzy () warpspeed com>
Subject: [Dewayne-Net] re: Wall Street Fears for Next Great Depression

[Note:  This comment comes from reader Andrew Odlyzko.  DLH]

From: odlyzko () dtc umn edu (Andrew Odlyzko)
Date: March 17, 2008 3:57:18 AM PDT
To: dewayne () warpspeed com
Subject: Re: [Dewayne-Net] re: Wall Street Fears for Next Great  
Depression

Dewayne,

It is pretty clear that nobody knows just how bad the financial crisis  
is going to get, or how it will affect the economy at large. But let's  
be a little skeptical of the doom and gloom stories, especially when  
they emanate from Wall Street. The one thing that the financial sector  
has gotten very good at is extracting money from taxpayers and small  
savers to cover up its mistakes.

In the research on my book comparing the Internet bubble to the  
British Railway Mania I have had occasion to read quite a bit of  
financial history. And the current crisis is, from a high level, just  
like any of the dozens of crises of the last two centuries. Somebody  
finds a gold mine, sacks of gold dust start trading, somebody else  
takes a sack, fills it with cow manure, putting a little bit of gold  
dust on top, and sprinkles it with perfume and starts passing it  
around as the genuine article. (This is very high level: There are  
obviously differences from case to case, sometimes you get credit  
rating agencies to slap their approval ratings on the sacks, sometimes  
you do something else.) Other people start doing the same, and  
everybody is happy until someone actually opens a sack and discovers  
it is mostly cow manure. And then we have a crisis, as nobody knows  
for a long time whether the cow manure sacks are 10, 20, or 90% of the  
total, and nobody knows precisely who holds them. But if you happen to  
be sitting on a bunch of sacks that you have not dared to open, but  
have smelled around, and with the perfume gone, you can tell there is  
a lot of cow manure there, you have a strong incentive to look for  
somebody who can be persuaded to pay you close to what sacks of real  
gold would have fetched.

There are various ways to get money from the public. Direct tax  
transfers are one. But not the only one, and in fact, they are to be  
avoided, since they are rather conspicuous. Remeber the "reverse  
toaster" proposal? Back at the height of the S&L crisis (almost two  
decades ago), there was a proposal for a fee on all depositors in  
regular bank accounts (something like 0.5% of deposits) to bail out  
the S&Ls. This went down in derision when Seidman (the head of FDIC)  
called it the "reverse toaster theory," in which instead of the bank  
giving you a toaster, you give the bank a toaster. Instead, what  
happened is that short-term interest rates were slashed dramatically,  
so that savers got nicked (not a single one-time 0.5%, but by perhaps  
2% a year for several years), and the banking system, which borrows  
short-term and lends long-term at higher rates, got recapitalized. And  
this is the typical approach. To make it more palatable for taxpayers  
and savers, frightening stories are useful.

At the beginning of the 19th century, the attitude was different. Then  
authorities told the bankers and merchants they had to take their  
lumps. But that started changing already in the middle of the 19th  
century, although slowly at first. Now as an antidote to the cynicism  
above, let me say that since those days, the business cycle has gotten  
a lot milder, recessions are far shorter and not as severe as they  
used to be, and growth rates in general far higher. Whether that is  
due to the bailouts by governments and central banks, or to structural  
changes in the economy (faster flow of information, less dependence on  
basics like food, ...) it is hard to say. And, of course, there is the  
fear that the assurance of government assistance may have induced the  
financial industry to concoct something so big and bad that this time  
the authorities won't be able to cope, and we may be in for the Next  
Great Depression. We'll see.

Andrew


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