Kevin M Warsh: The Panic of 2008
Speech by Mr Kevin M Warsh, Member of the Board of Governors of the US Federal
Reserve System, at the Council of Institutional Investors 2009 Spring Meeting,
Washington DC, 6 April 2009.
* * *
Deterioration in employment conditions. Pullback in consumer spending. Decline of industrial
production. Retreat in capacity utilization. Falling capital expenditures. These measures are
objective, all-too-familiar indicators of recessions. They emerge during periodic troughs in our
economic history. They are thought by most observers to be part of the business cycle. The
decennial recessions of 1981-82, 1991-92, and 2001-02 were of differing causes and
consequences. But they were alike in one key respect: They were extremely disruptive to
countless workers, businesses, and communities. In the case of the United States, these
periods were endured, and growth resumed apace, matched by new opportunities. The
march of growing prosperity, however imperfect and interrupted, continued.1
Fear. Breakdown in confidence. Market capitulation. Financial turmoil. These words are
different, not just in degree but also in kind. They are more normative, but no less
consequential to the real economy. They are indicative of panic conditions. In panics, once
firmly held truths are no longer relied upon. Articles of faith are upended. And the very
foundations of economies and markets are called into question. Some economists, market
participants, and historians - not so long ago - were prepared to relegate these highly
charged descriptions of despair to the dustbin of history. Government policies improved,
understanding of economics deepened, and markets found a more sustainable equilibrium,
or so it was thought.
The period of the past 16 months is already well chronicled in the popular lexicon as a
recession. The recent data are consistent with the view that this recession will endure longer
and be deeper and broader than most. Characterizing the current period as a "recession" is
still wanting, insufficient in some important respects. In my view, this period should equally
be considered a panic, one that preceded, if not made more pronounced, the official
recession. Hence, the Panic of 2008, which preceded the calendar year, is a more revealing
description of the recent economic and financial travails. As I will describe, panics involve
generalized fears - often related to financial firms - that magnify economic weakness. The
encouraging news, I should note, is that panics end. And this panic is showing meaningful
signs of abating.
The storied panics in U.S. economic history were generally marked by widespread bank runs
as depositors lost confidence in large segments of the banking system.2 Such was the case
in the Panics of 1837, 1857, 1873, 1893, and 1907. Depositors withdrew funds and hoarded
cash, generating increases in currency holdings relative to deposits.3 This loss of confidence
was not limited to individual depositors.4 During these panics, banks lost confidence in one
another. Banks withdrew funds in interbank deposits held at money center banks - then the
central repositories for the reserves of the country's banking system. Increased withdrawals
of interbank deposits exceeded the money center banks' ability to meet demand, and
payments were suspended to other banks. The scramble for funds spilled over into the
money markets, where rates on call loans to brokerage houses, considered at the time to be
very liquid investments, soared to extreme levels.
Sound familiar? This series of events from a century earlier echoes the events of our time.
Panic manifested itself in the summer of 2007. Asset-backed commercial paper markets
seized up in the United States and abroad. Commercial banks lost confidence in each other,
putting pressure on overnight London interbank offered rates. Strains intensified in the spring
of 2008 when Bear Stearns could not borrow even on a secured basis. And then the panic
intensified further in the fall of 2008, as interbank funding markets stopped functioning and
overnight rates soared to extraordinary levels. When one money market mutual fund "broke
the buck," fears were raised about others. Fund outflows escalated rapidly, threatening the
stability of short-term funding to businesses and municipalities. Confidence in money center
banks plummeted, as was the case a century before. And market participants lost trust in
their counterparties. Extraordinary actions, however, have been taken - with some notable
success - to lessen panic conditions.
Panics involve losses of confidence in the financial system, when even sound firms find it
difficult to borrow. Panics are threatening to economic well-being. Panics take even less
kindly to, and often result from, uncertainty. And panics place a greater burden on the
deftness of policy responses than recessions alone. Our economic history contains many
contractions in output - and losses in wealth - that were unconnected to panics.5 In the
Panic of 2008, however, the breakdown in the financial sector has contributed to, and
exacerbated, the economic downturn.
Economic and financial conditions
The current financial and economic turmoil is marked by indicia of both recession and panic
conditions.
By official measures, the current recession is already significant in scale, scope, and
duration. And the deterioration in employment conditions in the current episode already ranks
comparably to the recession of 1981-82. The unemployment rate is 8.5 percent and likely, in
my view, to increase steadily through the balance of the year.
Economic output, as measured by gross domestic product, contracted at a rate of about
6-1/4 percent in the fourth quarter of 2008 and is on track to contract sharply again in the first
quarter, which would put the current contraction among the most severe post-World War II
recessions. Though the pace of decline is likely to abate, I am decidedly uncomfortable
forecasting a sharp and determined resumption of growth in the coming quarters. The panic
conditions that have marked this period may also have long-run implications. I suspect that
the process of an efficient reallocation of capital and labor will prove slower and more difficult
than is typical after recessions. Policymakers should be wary of policies that make the
economy still less capable of the growth, productivity, and employment trends that have
marked the postwar period.
In the United States, average stock prices have fallen by 40 percent in 2008 and another 6
percent this year. The average market capitalization of large banking firms plummeted 50
percent in 2008 and continued to fluctuate significantly this year as uncertainty about their
earnings prospects, potential balance sheet impairments, and sustainability of business
models intensified. Greater clarity as to policymakers' objectives for financial intermediation
would likely prove very constructive to financial markets. More consequentially, in my view, it
would improve the prospects for economic performance.
In the household sector, Federal Reserve data indicate that household net worth fell $11
trillion in 2008, or about 18 percent, the largest annual decline recorded.6 Relative to
disposable income, household net worth fell from a ratio of about 6 to one to less than 5 to
one, erasing about a full year's worth of income in wealth. For the median household, net
worth is estimated to have decreased at a greater rate - 23 percent in 2008.7 Household
balance sheets may have contracted about another 7 percent in the first quarter, and I am
watching keenly for that trend to change in subsequent quarters as part of the recovery.
House price declines accounted for much of the decline in net worth for the median
household. But, more than in previous periods, household wealth was harmed by declining
share prices through direct equity exposure and retirement plan holdings. Households are
thus confronting the risks of income statement shocks through job losses and more
significantly correlated changes in the value of virtually all other assets. The heightened
concern about these risks is indicated by the extremely high equity risk premiums, which
reflect, among other factors, the risk that investors who suffered a loss in income may also
be forced to sell their stocks when valuations are low. Traditional rules of income and asset
diversification appear to offer scarcer protection than generally advertised. As a result,
households are questioning the route to financial security. Homeownership is no longer
perceived to ensure low-risk capital appreciation. And assurances by investment managers
to invest in "stocks for the long haul" are being subjected to intense scrutiny. Investors of all
stripes - sovereign wealth funds, large long-only institutional investors, private equity
sponsors, hedge funds, and retail investors - are searching for new rules of asset allocation
and appropriate risk premiums in an uncertain and unusual economic environment.
In a typical recession, the mix of balance sheet contraction by households and businesses
and of trends on employment and production would pose meaningful challenges for
policymakers. I would argue that the challenge is exacerbated when recessionary dynamics
are compounded by panic conditions.
Fundamental reassessment
Previously, I argued that we were witnessing a fundamental reassessment of the value of
every asset everywhere in the world.8 This diagnosis seems truer, and still more troubling,
today. The trading of legacy loans and securities continues to reveal systematic underpricing
at issuance of once seemingly benign risks - credit, liquidity, counterparty, and even
sovereign risks - which are demanding continued reassessment and recalibration. Until
these assessments are more cleanly refined and more broadly understood, we are likely to
observe elevated levels of volatility and unwillingness by many investors to participate in
certain asset markets at virtually any price.
The ongoing reassessment of these risks continued through the first quarter of 2009. Some
financial markets and economic actors are still searching for a new equilibrium; others
appear to have called off the search teams altogether until the new equilibrium arrives. Since
the beginning of 2009, global equity markets have fallen about 15 percent, and the global
market capitalization of financial institutions generally underperformed the broader indexes.9
Few sanctuaries appear to exist from the recession and corresponding global asset
revaluation.
These real-time economic and financial market indicators surely describe recessionary
conditions, a period of significant economic weakness and a global revaluation of asset
values. But the depth and severity of this downturn are due, I believe, to a more profound
panic phenomenon. Market participants wonder whether the forms of financial intermediation
and functions of financial institutions - long connecting savers with investors - will be
implemented in a manner that will enhance, or reduce, economic well-being. Some are
questioning the efficacy of the remaining vestiges of the existing financial architecture and
remain uncertain of the timing, efficacy, and policy preferences for the financial architecture
that will ultimately emerge. Surely, they applaud the goal of policymakers to reform the
financial system to make it more durable through the cycle and less susceptible to shocks.
But some query whether policy actions are, on balance, lessening or stoking panic
conditions.
Articles of faith
Headlines have been dominated in recent weeks by the legal rules that govern contracts. To
be sure, markets function best when economic actors comport themselves in a manner
consistent with the rule of law.10 Fidelity to the rule of law is not just some aphorism for a
judicial system to protect property right disputes among private parties. Nor should it be just
some preachy truism of economic development for emerging economies. Rather, it is the
linchpin of modern market economies like ours. And it suffers its greatest blow when the
governing authorities are unwilling to uphold their end of the bargain. Nonetheless, despite
some highly publicized suggestions to the contrary, I remain highly confident that the
government will work tirelessly to uphold its obligations. Hewing to the rule of law, however,
may be the easier part.
The panic bred by the loss of confidence in the underlying financial architecture is difficult to
remedy beyond the purview of statutes and regulations. A weighty accumulation of unwritten,
but no less critical, practices and understandings governs behavior and establishes
expectations in market economies. Over time, these informal understandings attract deep
and loyal followings by economic actors. They become articles of faith. Deviations from them
tend not to be illegal, but they can markedly change perceptions of risk and return. When that
happens, the resulting expectations are unmoored, with significant and often highly
detrimental consequences for market functioning and economic progress.
Panics can thus be understood as periods in which key articles of faith are cast in doubt.
How does this happen? After long periods of economic prosperity - in the most recent case,
the so-called Great Moderation - articles of faith accumulate. Some of these understandings
are strong and enduring and well grounded; others, more problematic or misplaced; others
still, properly and promptly discarded. Some of these articles of faith are rooted in
government policies; others develop as a matter of private practice. Regardless of their
cause and contour, when faith is undermined, the resulting fear and ambiguity can accelerate
the deterioration in economic performance.
Some key articles of faith have been undermined with respect to some financial institutions.
And that is as it should be. Risk-management failures at some large, systemically significant
financial institutions are now legendary. In some cases, investors and counterparties came to
rely to their detriment on these entities and their financial wherewithal. As wholesale funding
markets became tougher to navigate, many financial institutions suffered, some rightly so.
But their stronger peers with significantly more robust risk-management practices also
appear to be paying a heavy price. It is difficult for the strong to thrive, let alone survive,
when they reside in a neighborhood that is being decimated. And when panic conditions
persist and long-held articles of faith lose their following, markets often react indiscriminately.
Government policies, in my view, should encourage differentiation among firms, even those
in seemingly close proximity. For policymakers to act otherwise is to risk their own credibility
and risk undermining the pace of economic recovery.
Market participants appear equally uncertain about the nature, objective, and duration of the
relationship between the government and financial institutions. Given the choices available to
policymakers during the past 24 months, some uncertainty is unavoidable. Consider the saga
of the government-sponsored enterprises (GSEs). In my judgment, the story of Fannie Mae
and Freddie Mac exposes perhaps the most consequential negative shock to the financial
system during this period.
For about a generation, the GSEs issued debt that was thought by virtually all market
participants to be backed de facto by the U.S. government. The GSEs traveled the world,
selling debt at rates and terms and funding schedules that were largely comparable to
Treasury securities. Some loud protestations aside, government policy - broadly defined -
tended to countenance investor expectations. At year-end 2007, the outstanding public debt
of Fannie Mae and Freddie Mac totaled about $5.0 trillion, roughly comparable with the
publicly held Treasury debt of $5.1 trillion, and spreads to Treasuries on their senior debt
amounted to about 30 to 50 basis points, even though the institutions were thinly capitalized
relative to their asset composition and risk characteristics.
In the fall of 2008, however, GSE senior debt spreads widened significantly to more than 500
basis points. Market participants grew increasingly skeptical of the GSEs' financial and
operational wherewithal and were uncertain of the depth of government support. When
markets decided to test policymakers, as markets are especially wont to do during panics,
the Treasury was forced to intercede, effectively taking control of the entities. Congress
authorized successive Administrations to take forceful actions, including appropriations of up
to $200 billion to-date, to assure investors and counterparties that the institutions would
remain solvent. These efforts, while necessary and well intended, have not completely
resolved the uncertainty around the GSEs to market participants. Indeed, even after
extraordinary actions most recently by the Federal Reserve to improve liquidity and market
functioning in the agency debt markets, confidence in the GSEs is less than markets were
long accustomed to before this period began.
When presumptively risk-free, highly liquid assets backed by the highest-grade sovereign are
subject to large swings in value, the risk-return profile of virtually all other assets becomes
highly uncertain. The resulting portfolio reallocation boosts demand for Treasury securities,
and reduces demand for assets that are genuinely riskier, placing upward pressure on risk
premiums across a wide range of markets. In addition, financial firms that had assumed that
their holdings of GSE debt were as good as cash were forced to reassess the adequacy of
their liquidity positions, adding to balance sheet pressures and leading to even greater
safehaven demands for Treasury securities.
Across a broad range of financial institutions and financial markets, an unhealthy mix of
recession dynamics and panic conditions appear at work. But, in my view, it is predominantly
the latter - the uncertainty with respect to financial intermediation and the corresponding
breach of articles of faith - that have exacerbated the downturn.
Conclusion
Let me offer several concluding observations that may help frame a new foundation for
growth and ensure that discarded articles of faith are repaired, reformed, or replaced.
The Panic began before the recession and will assuredly end before it. Getting the financial
intermediation process to function with greater efficacy - even before a new financial
architecture is firmly established - is a necessary condition to a sustained recovery.
The Panic is the result of both faulty private practices and flawed public policies. To place
blame either exclusively on private financial firms or chiefly at the doorstep of the official
sector is incorrect.
Financial stability demands policy stability. The official sector's policy preferences must be
communicated clearly, credibly, and consistently and backed by concrete action.
To accelerate the formation of a new financial architecture, the official sector should outline
and defend a positive vision for financial firms and welcome private capital's return. The
nature and terms of the relationship between financial firms and the official sector should not
be left in limbo.
Finally, and perhaps most important, policymakers across the government must be ever
mindful of the long-term consequences of their actions. Fluctuations in economic output and
employment are unavoidable. As a result, policymakers' objective should be more humble:
Maximize sustainable economic growth while reducing the incidence, severity, and economic
fallout of future shocks. And we must ensure that the long-heralded strengths of the U.S.
economy - the resiliency and dynamism in our labor markets, product markets, and, yes, our
financial markets - are allowed to flourish. In so doing, trust will continue to displace panic in
our markets, and our economy will ultimately rebound with great vigor and even greater
promise.