Surviving a financial panic -- lessons from the past

By Philip Brewer on 13 October 2008 (Updated 6 December 2008) 15 comments

Financial panics used to be quite ordinary.  In the century or two prior to the great depression, there was a panic every 15 or 20 years.  Since the great depression we haven't had a classic financial panic, until now.  There's a thing or two that we can learn from panics past to help us survive the current one.

To begin with, there's a reason why we haven't had financial panics for the past 75 years--fiat currency.

Panics and gold

Panics used to begin when people decided to get their hands on actual, physical gold.  That could happen for a lot of different reasons.  Often it was because there had been inflation--banks issuing bank notes far in excess of the gold they had on deposit--and people decided that they didn't trust their bank.  Sometimes, though, it happened without any particular malpractice by the banks, simply because there was a demand for gold someplace else--an economic boom in Europe or South America could drain gold from the United States or vice versa.

Since issuing banknotes was literally printing money, the temptation to go overboard was immense, and individual banks that did so used to collapse all the time.  A prudent bank, though, could be modestly profitable and a great boon to its community, but in a panic, even prudent banks would fail.  (You could, in theory, create a panic-proof bank that held enough gold to pay off every banknote, but it would be a money-losing institution.  Holding all its gold in its vaults, it would be unable to make loans, but would still have to pay for a building, tellers, security, and so on.)

Prior to 1933, it was very hard to address a panic, because there wasn't enough gold.  Sometimes, if a panic started small, it could be headed off by large banks (or even wealthy individuals) lending gold to the banks that were under pressure.  The banks could then redeem enough banknotes to satisfy worried note holders.  When the panic subsided, gold would flow back to the banks, they could pay off the loan, and things would return to normal.  

In the case of a large panic, though, the banking system as a whole didn't have enough gold to redeem enough of the banknotes.  Banks would pay out gold for a while, hoping that they could thereby demonstrate their soundness.  Once it became clear that the gold on hand wouldn't satisfy the demands of note holders, the bank would suspend note redemption.  Note that, even when that happened, depositors and note holders didn't necessarily lose everything.  In many cases, the bank was actually solvent.  As their customers went on paying their debts, gold would gradually flow back to the bank, allowing it (at some point) to resume redeeming its notes.

Since 1933, there hasn't been any gold backing the banknotes anyway, a condition that had seemed to have eliminated the possibility of a classic panic.

And yet, here we are.  So, what were the keys to surviving a panic in those days, and how do they apply today?

Liquidity

The first way a panic works its harm is by destroying liquidity.

Once a panic started, the first things to go was the payments system.  In normal times, people could spend banknotes as easily as they spent gold and could pay their bills with checks.  In a panic that isn't true.  Every transaction becomes its own negotiation.  Payment in gold is fine (although you have to be sure it's real gold).  Payment in the notes of a sound bank is okay, but opinions differ regarding which banks are sound and which aren't, leading to confusion and disagreement--the result is a whole sliding scale from the sound banks to the iffy banks to the banks that have suspended redemption of their notes but are still open to the banks that have closed.   Checks have the same issue of bank soundness, only it's layered on top of the question of whether or not you've got money in your account.

Adding that sort of negotiation on top of every transaction was obviously a nightmare.  So, if you want to understand why central bankers, finance ministers, and politicians are in such a tizzy, imagine layering those issues on top of the complex payment systems that we use now.  

Today, checks are clearing, credit and debit cards work fine, the ATM machines have money, direct deposits are going through on schedule, automated clearing house payments for bill payments and bank transfers are all working smoothly.  This is a huge win for the economy.   Just imagine what happens if those systems start to break down--if your transfer from your internet bank doesn't show up in your local bank, if your credit or debit card starts being declined, if your landlord and the power company stop taking checks and start wanting you to show up in person with cash in hand.

If it was just liquidity, though, the problems would be manageable.  Cumbersome, but manageable.

Solvency

The second way a panic works its harm is by destroying solvency.

As a panic began to set in, a business with merely adequate capital could suddenly find itself on the ropes.  Its customers would start paying at the last possible moment, and then start paying late (and, in many cases, going bust and not paying at all).  At the same time, its suppliers would start cutting credit limits, pressing for early payment, and then demanding payment in cash.  On top of that, its bank would refuse to lend.  If you had the cash to bridge the gap--paying your bills on time, even though people were paying you late--then you were fine.

It wasn't that simple, of course.  If your bank failed it didn't make much difference how much money you had.  The wealthy could take measures--dividing their money among several banks and holding some amount of physical gold for example--but those strategies were largely closed to the poor (who couldn't scrap together enough for one bank account, let alone two, and who didn't have a safe place to store gold even if they  could put their hands on some).  They were also largely closed to businesses, who had their money invested in the business, not sitting around just in case their customers started paying late the very same week their suppliers started demanding payment in cash.

The key, then, to surviving a nineteenth or early twentieth century panic was to have ample cash, to choose your bank carefully, and to have some actual physical gold on hand.  In particular, being one of the first people to panic--showing up to turn your banknotes into gold while the bank was still paying in gold--was the winning strategy.  The result was bank runs that could bring down even sound banks.

Since there's deposit insurance to protect small and medium-sized depositors--and since there's no gold at the bank to be gotten anyway--we do seem to have largely eliminated bank runs, and largely eliminated the need for ordinary people to participate even when there is one.

Still, the solvency issues remain--if customers can't pay, even a well-capitalized business can't continue to operate for very long.  And, as businesses cease operations--or simply shrink to the point where they're sized to service the fraction of their customers who can pay--employees find themselves out on the street, facing their own solvency issues.

And solvency issues are why, even though they're not obliged to back deposits with gold, the banks are failing.

ARTICLE CONTINUES BELOW

Our new panic

Even sound banks can fail in a panic, if they're obliged to pay out gold, simply because there isn't enough gold in the system to pay off all the banknotes at once.  Since our banks aren't obliged to pay out gold, sound banks aren't really at risk--even if they don't have cash on hand to pay off all their depositors, as long as they have assets (generally, loans that are being paid back), they can get unlimited cash from the central bank.  In this situation, what would have been a panic is merely a credit squeeze.

So, how come banks are failing in our current panic?  Basically, a lot of the banks aren't sound.  Their assets, instead of being mortgages on local homes and loans to local businesses, are instead huge amounts of the sort of "securitized" debt that you've no doubt heard about--groups of mortgages, auto loans, credit card debts, and so on, all packaged up and divided into slices that were supposed to have predictable risk characteristics (but that turned out not to).

Presumably, not all the banks are in trouble.  So, a second problem is that nobody knows which banks are solid, which banks are iffy, and which banks are just waiting for the coroner to sign the death certificate.

(That's why the Treasury's plan was to buy up a large amount of this securitized debt.  The idea was, if you could put a price on those iffy securities, the sound banks could resume normal operation.  If the price was high enough--higher than the assets are really worth--many of the iffy banks would be okay as well.)

The result has been a situation a lot like a classic financial panic, even without the issue of a shortage of physical gold.

A few words about gold

In panics past, the key winning strategy was to move to gold before banknotes lost all their value.  I don't think that's a useful strategy this time.  Gold may be a winning investment, but it lacks the key attribute that made it a winner in the past:  it isn't cash.

Until 1933, contracts were often written in terms of gold dollars.  If your banknote wasn't backed by gold--if your bank had closed or suspended payment--you couldn't use it to pay your bills.  That's no longer true.  The value of the dollar may soar or crash in terms of its international value and it may lose its value slowly or quickly to inflation (or even gain value due to deflation).  But you can be reasonably sure a dollar will continue to be worth a dollar when it comes to paying your bills.  That's something that people didn't have going for them in the panics of the nineteenth and early twentieth centuries.

Gold may (or may not) be a great investment, but it's a crappy way to pay your bills.  For that, you need money--regular old bank deposits and currency.

The hard money folks like to say that gold is the one financial asset that isn't someone else's liability.  In a world where many liabilities are not being honored, that's a big deal.  But as long as your liabilities are in dollars (or euros or pounds or krona), you want to have cash on hand to pay your bills.  For example, I'm just three months into a one-year lease.  I know exactly how many dollars I need to pay to keep my apartment for the next nine months.  I have no clue how much gold I'd need.

As an aside, it seems that there actually is a shortage of physical gold.  Perhaps in part because a rather new fund (SPDR Gold Shares) has been buying huge amounts of gold and storing it in vault--enough that its gold reserves recently passed those of Japan.  Fabricators of gold coins  are having trouble getting their hands on enough to meet demand.  That's a situation that can't last for long--people will bid up the price of physical gold high enough to draw those large gold bars out of the vaults.  That makes gold sound pretty good as an investment--but it doesn't turn it into cash.

Strategies for survival

Knowing that the keys are liquidity and solvency, there are some obvious strategies to begin with.

Don't depend on credit.  Arrange your finances so that you can fund everything with cash.  If you're a business, this will inevitably make you less profitable, but less profitable is better than being out of business.

Keep your assets safe.  Even if you avoid debt, you still have obligations that need to be met--rent, taxes, utility bills, etc.  If your income is uncertain (and it is), then you want to have cash on hand to meet those obligations.  Things like bank deposits (under the insurance limits), money market funds (now also insured), and Treasury securities are very safe and very liquid.

Cut expenses and diversify your income.  Having liquidity is key in the short term, but over the medium to longer term the key is to make sure that your expenses don't exceed your income.

Later, buy valuable stuff cheap.
  As the panic winds down, large amounts of valuable stuff will be on sale cheap, because those who were not liquid enough will be forced to sell.  If you've got cash at that point, you're in a position to make some outstanding investments.

These were the strategies for surviving panics in the past.  They're still the strategies today.  The one good thing about a financial panic is that it (unlike, say, a war) doesn't destroy the actual productive capacity of the economy.  The factories are still there, workers are still there, the land is still there.  Staying liquid, and making sure that your expenses don't outstrip your income, will get you through to where that underlying productive capacity can come to the fore once again.

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Guest's picture

Great post, Philip. I really appreciate how you broke things down for us into simple, comprehensible terms. The current economic crisis is pretty confusing to those of us who are non-experts, but I feel that often, the concepts behind the crisis are left unexplained, which in my opinion, probably leads to further panic among the general public. After all, we tend to fear that which we do not understand.

Guest's picture

Advice is to continue to invest on a regular basis; Proper allocation among stocks, bonds, and cash is vital; Only shift investments if you would not buy them at the moment.

Guest's picture

Thanks for posting such an informative article. Always stay the course and continue to invest throughout difficult times.

Guest's picture
Kablamo

Great article, an excellent and concise explanation of the current situation with sensible advice. The recommendations you make seem to be cropping up more and more in the media these days - however I think you've gone the extra mile by adding "later, buy valuable stuff cheap". This is absolutely true, there is both hope and opportunity despite what is going on.

This isn't to say any investment (or purchase) at a heavy discount is worthwhile; but if you have or can attain the capacity to move in this environment, there is a lot of potential.

Guest's picture

Phillip,

Thanks for your great article. It is clear how well researched this is. It is interesting that the large number of banks in the US, while creating competition, also brings some of the instability; because like you said, you don't know which banks are solid and which are not. In Canada, where there are only a handful of banks, people have more trust in the long-term future of their banks. In fact no banks went out of business in Canada during the Great Depression.

I like how you end your article with such great tips. I recently wrote an article about how to Simplify Your Budget that can help people to not depend on credit and to cut expenses. The article is: http://successprofessor.ca/2008/09/24/simplify-your-budget/

Guest's picture

Phillip,

That article was amazing. I never really took the time to think about why a bank would fail. My expertise is engineering, and although I've been paying more attention than ever (if that means much from a 24 year old), I've never had the word "crisis" explained in such a way that I could understand. I also agree with a previous comment, that if the general public would just live normally, then allot of this crisis could be subsided. Linking that to a lack of understanding, I think that a true "bail-out" may just be that - more understanding.

Caleb
www.mefinanciallyfree.blogspot.com

Guest's picture

I just wanted to echo what everyone is saying. This post was one of the most informative I have read since this scare began.

It always comes back to living within your means doesn't it?

Thanks for writing this...

Guest's picture
SlaveToMyLenders

Thanks, Philip, for this informative post. It's one of the clearest explanations of why the banks are in trouble that I've seen.

By the way, you mention that there aren't runs on banks this time. Just a year ago in the UK there were lines of people at the door of a bank called Northern Rock. They were the first UK casualty to the liquidity crisis initiated by the sub-prime loan fallout. See http://en.wikipedia.org/wiki/Northern_Rock if you're interested.

Keep up the good work!

Philip Brewer's picture

Right.  As I said in the article, bank runs had been largely eliminated by deposit insurance--but largely eliminated is not completely eliminated.

In the UK, the deposit insurance limits were quite low--low enough that the deposits of ordinary small savers were at risk.

In the US, the deposit insurance limits were high enough that most ordinary savers' balances were protected--but businesses and other institutions with large balances were at risk.

The result was a return of the bank run.

Who would have thought that we'd see the day?

I should note that both the UK and the US have raised the insurance limits.

lghbob's picture
lghbob

 

Philip...

I agree with all, except that I believe the underlying problem with liquidity, goes beyond the collaterized securities... I believe that the problem comes from the inablility to settle derivatives.

 

I think it's too simplistic to assume that there is a way to value these instruments.   It is patently impossible for the government or all governments to try and buy "bad debt", when the amount of these transactions totals more than 500Trillion Dollars.  Yes... I understand "notional value", however each of the transactions that represent the basis for this estimated total, is...in fact, a contract, that must be settled between two parties.

 

The slicing and dicing, and the calculus based risk factoring has effectively precluded any resolution of  the settlement process.

 

In short... there ain't no way to fix this, and until it's fixed, there is no way any government program  will do more than pour taxpayer future debt into the coffers of the banks and financial institutions.

  

The super smart folks who created this monster are at the bottom of the problem.  Bad as it may be, letting them fail is the only logical and legal answer.

 

Will it hurt? Worse than the worst depression or physical catastophe that today's world has ever seen.  It will mean going back to square one, effectivley building a new financial world.  As a retiree, I'll be at the bottom of the barrel.  

 

But!!!

The smart people will build this back up in a hurry.  (Remember the fall of the Ruble and the recovery).  We'll have a year of hurt... But the world won't come to an end.  We'll come back faster and stronger than ever, and the people who took the money in the first place will be the ones who will take the biggest part of the loss.  Yes, they'll still be wealthy, but instead of $50 million, they'll have $5 million dollars.  And the loss of their money will settle the hedge fund/derivative bubble.  

 

The longer Mr. Paulson and Bernancke play with an unsolveable problem, the greater our debt and the debt of our children.

 

We have laws to deal with financial situations... bankruptcy or reorganization.  For the life of me, I can't understand how we ignore these laws.   Our government is both ignorant and corrupt.  

 

As they say, you can pay me now, or pay me later.... later may be a third world country and anarchy. 

 

 

my opinion only

Philip Brewer's picture

@ lghbob:

I can't say you're wrong, but I'm a little more hopeful than that.

My hopefulness comes from the fact that almost all the derivatives that you're talking about have underlying securities that are self-liquidating in some way.  The mortgages, car loans, and so forth have maturity dates, so eventually every one of them will either default or else be paid off.  Even the credit default swaps have underlying bonds that will eventually be paid off (or not).

The ordinary bankruptcy process could handle that--the situation where the underlying securities still have value (e.g. 90% of the mortgages are still being paid on schedule), but the derivative can't be priced because no one will buy it.  Where it falls down is handling institutions that are "too big to fail."

The Treasury and the central bank are hoping against hope that, if we can just muddle through for a little while, we'll get to the point where the derivatives do have a price again.  If it isn't too low, we'll be able to save more banks; if it is low, we'll be able to save fewer.  Either way, we won't have to build our financial system from the ground up.

I don't know if Paulson's plan can work.  It could well happen that the banks will start by sticking the Treasury (i.e. the taxpayer) with the worst of their "troubled" assets--the ones that turn out to be worth only pennies on the dollar--and just keep handing over worthless paper until the money's gone.  But it could work the other way:  with a buyer for even the junkiest of the paper, all the institutions may well start trying to re-jigger their portfolios--buying and selling, trying to make a profit.  If there was a market for the paper, so that it had a value, we might still lose a lot of banks, but at least we'd know which ones were gone.

I worry about your scenario, but I'm hopeful that we can do better.  Not confident, but hopeful.

lghbob's picture
lghbob

You can't know how much I hope you're right.  Time will tell, but time is what I'm afraid of... Don't know if we can let this go on...

 

Here's a quote from today's WSJ about the unravelling of Lehman Brothers alone.

................................................................................................. 

 

"Lehman Brothers Holdings Inc.'s legal and financial advisers said Thursday they plan to hire about 200 professionals to help settle the more than 1 million derivatives trades the investment bank entered into before it collapsed last month.

Lehman attorney Harvey Miller said at a court hearing that advisers are working around the clock to understand Lehman's transactions in the wake of the "chaos" that resulted from its Sept. 15 bankruptcy filing "

.......................................................................................................... 

 

My thinking is that they (the professionals) won't succeed. 

 

my opinion only

Guest's picture
funkright

"My thinking is that they (the professionals) won't succeed..." nothing like positive thinking to help us all make it through the day.. Sheesh.. let's think a little more optimistically...

Guest's picture
steve

The poster's stating his or her assessment of the situation is being honest. I prefer that to false "positive thinking". Positive thinking doesn't always make "bad" things go away.

Guest's picture
Chris MacPhail

Great advice, well stated. Thank You!

Under "Later, buy valuable stuff cheap" I would say "not too much later." If you wait till the panic/recession is clearly winding down, stock prices will already have moved up a lot.