This is the Wizards of Money, your money and financial management series … but with a twist. My name is Smithy and I’m a wizard watcher in the Land of Oz.
This is the tenth edition of the Wizards of Money and it is entitled “Back to the Twenties Through the Looking Glass – Steagall”.
In this the 10th edition of Wizards we are going to take a look at the parallels between current times and the late 1920s – the period just before the great stock-market crash of 1929 and the subsequent Great Depression. We will see how it is that much of the regulation implemented during the Great Depression to address the wild and unregulated behavior of big business during the twenties has now been dismantled through de-regulation. Despite industry claims that such regulation is out-dated and no longer needed for our fancy modern markets, we will see that, not surprisingly, the dismantling of this regulation has once again given rise to exactly the dangerous market behavior it was designed to stop.
Excerpt FDR Inauguration Speech 1933 – Reign in Bankers
This excerpt from FDR’s 1933 speech helps remind us of a time when financial collapse caused by unchecked and unregulated behavior of Wall Street gamblers forced America’s political leadership to publicly recognize the danger such activity poses to the public as a whole. But how easily we forget these things. In the wake of the undoing of what became regulated during the FDR administration the same old players are back to their same old tricks of the twenties. Hardly discussed in all the coverage of the Enron Saga of the early 21st century is the discovery of the extent of the wild and risky behavior of the biggest federally insured banks in the US – JP Morgan Chase and Citigroup. If their involvement in financing various Enron activities is an indication of their wheeling and dealing more broadly then we have a lot to be worried about at the heart of the financial system.
In this highly deregulated market it is appropriate to look at the implications for another 1929-style crash and the potential for a financial collapse. The 29 Crash followed the high stakes risk-taking of lightly regulated powerful industries. One must consider – Would a financial collapse of this scale be a good thing? – by being possibly the only way to change the global order? Or would the first such collapse in the nuclear age bring more violence and destruction than any of us ever thought possible? Of course nobody can answer these last two questions with any certainty, but it is very important to consider what might go into the makings of a global financial collapse and to plan for what is eventually going to happen anyway. It is not a question of whether or not it will happen – as all financial systems eventually collapse, but the question is – when.
To go on this journey we will hear some speeches from important figures from this time and we will also visit with some people that actually lived through the twenties and are still able to tell us about it today.
2. Regulatory Landmarks of the Great Depression
The Great Depression brought with it numerous regulatory landmarks that stayed with us for a long time. Let’s just talk about a sample of four of the major areas and the status of them today:
- Utilities Regulation: In 1935 the Public Utilities Holding Company Act or PUHCA was introduced to provide national supervision of the gas and electricity utilities in order to prevent their excesses of the 1920s. In the twenties big utilities had been buying up smaller ones, hiking up consumer prices, expanding into unrelated businesses, loading up on debt, hiding losses from investors, and milking their subsidiaries and affiliates to prop up their own earnings. Sound familiar? Many people have reminded us of this law in the aftermath of the Enron collapse and Enron’s various exemptions from it amidst recent recommendations by everyone from the Senate Banking Committee to the SEC to have this law repealed.
- Exchange and Accounting Regulation: The Securities and Exchange Commission (or SEC) was established in 1934 under the Securities Exchange Act. During the 1920s there was effectively no Federal oversight of the securities markets, and with the market rising in the 1920s, and banks more than willing to lend for stock speculation, this created a recipe for disaster. The SEC was created to oversee market players in the securities markets and to require truthful quarterly reporting from publicly traded companies. By 2002 the effectiveness of the SEC in enforcing “truth in reporting” is highly questionable as we have seen. This is in part due to conflicts of interest rife throughout the financial world but also due the sheer complexity of financial transactions available to all companies and the absence of regulation on the most risky of financial transactions – those called derivatives trades.
- The Social Security Act: Before the Great Depression there was no federal safety net for unemployed, disabled or retired persons. As often happens today the safety net was usually picked up by various charities and religious organizations. But this safety net collapsed during the Great Depression because of the collapse in confidence in the financial system. By necessity and through public pressure that had built up over the years the Social Security Act was born in 1935 and provided for old-age and unemployment benefits. Today, of course, this depression era safeguard is under attack with financial companies pushing for its privatization.
- The Heart of the Financial System: Finally the big one – the regulation of the system that stands at the heart of the entire financial infrastructure – the banking system. The big act affecting the banks and securities dealers was the Glass – Steagall Act of 1933 that brought radical changes and better supervision to the banking industry. This act separated deposit banks, where depositors expect to safely park their money, from more speculative players such as securities dealers and investment banks that could make depositors’ money disappear through careless gambling – and did exactly this in the 1920s. The Federal Depository Insurance Corporation or FDIC was set up in 1933 to provide insurance on depositors’ funds in the event of bank failure. This was necessary to restore confidence in the foundations of the monetary system – the banks – that had just seen run after run, failure after failure, and depositors had seen their money disappear right before their very eyes.
Interestingly, also at this time, various controls and regulations were put on the Savings and Loans institutions. This was all to be undone when Ronald Reagan began his de-regulation kick in the 1980s. As we now know the undoing of these regulatory checks and balances precipitated in the Savings and Loans debacle of the 1980s that could have brought down the world financial system, except that the US taxpayer saved the day with a high priced bailout. That is what Federal Insurance means – backed by the US taxpayer. With the repeal of Glass-Steagall protections in 1999 nobody seamed to have remembered the lessons of the 1980s, let alone the lessons of the 1920s!
These regulations of the banking system – the heart and soul of the financial system – will be the focus of our show today. We will see how the gradual dismantling of them over the past 20 years, since Ronald Reagan took office in 1980 and culminating in the complete repeal of the once mighty Glass – Steagall Act in 1999, is sending the banks straight back to be bigger reflections of their 1929 former selves. Whatever are the implications of this? As already noted a glimpse at what the future might hold already leaked out amidst the Enron crisis. We are only just starting to understand the extent of the involvement of big federally insured banks in this scandal, notably JP Morgan Chase and Citigroup – both of whom were able to form banking and securities trading conglomerates after the repeal of Glass – Steagall.
Much of the source material on the 1920s used for this episode of Wizards is actually from the web-site of the Library of Congress. This site has a very extensive selection of original documents scanned into electronic files and posted to the Web. For the 1920s era there is a fascinating collection called “The Coolidge Era and the Consumer Economy” and links to this are posted to Wizards of Money Web site at www.wizardsofmoney.org
Link to the Library of Congress 20s collection http://memory.loc.gov/ammem/coolhtml/coolhome.html
Now let’s get in our time machine and go back to the 1920s…
Excerpt – Einstein Speech…Language, Science and Goals
This is a rare recording of Albert Einstein. I inserted these words from Einstein because, of course, Einstein was becoming a very famous person in this period known as the Roaring 20s and he was traveling in the US to explain his amazing Theories of Relativity. These theories made him the premier Time Traveler of Western History. In particular, his Special Theory of Relativity provided the Western world with a radical new look at the concept of time, and it implied strange time travel and time-space paradoxes. He notes in this speech the role that science plays in the world, and that it is leaders who set the goals and priorities first and science that follows, rather than the other way around.
Now imagine we are back in the twenties … World War I is over, the Republican Harding is President and the decade started glumly with what is known as the Agricultural Depression.
Radio was the new mass communications medium of the 1920s. The Westinghouse Company launched the first radio station KDKA in 1920 in Pittsburgh, Pennsylvania. Radio brought with it great promises as the medium for free speech and democracy … but these promises were never fulfilled in the twenties, as we shall see.
Campaign finance and corruption scandals rocked the Harding administration, the most famous being the Teapot Dome Scandal, whereby government officials had secretly leased public oil-fields to private interests in return for cash and other favors. Harding had an unfortunate incident with some foodstuffs in 1923, he dropped dead and Calvin Coolidge became president and served as such until 1928.
The Coolidge Administration favored deregulation, industry self-regulation and brought in tax cuts to stimulate spending.
ATT, NBC, and CBS built huge radio networks across the country that grew rapidly in the last half of the decade. These networks were all supported by advertising revenue and this tended to “dumb down” the content so as not to offend the major revenue sources.
The public relations industry and major corporate propaganda campaigns were launched. Spearheading much of this activity was a man named Edward L Bernays who wrote extensively on “The Business of Propaganda” and helped Coolidge get elected in 1924. Advertising in newspapers and radio claimed unprecedented proportions of print-space and airtime.
Various movements to encourage ever more spending were launched – such as the Better Homes Movement, and various targeted Women’s and Negro consumer campaigns were launched. Marketing specifically to children kicked off with the first annual Macy’s parade in NY in 1924. Target marketing statistical analysis reached new levels of sophistication with the introduction of the punch-card system.
America had reached new and amazing heights in consumerism!
Popular radio shows, the new talking movies and song/dance combos such as the Charleston engaged millions and helped the decade become known as the “Roaring 20s.”
The Chain Store was born. Sears, Roebuck and Company opened 324 stores nationwide between 1925 and 1929. Woolworths, Krogers, JC Penney, and Walgreens all spread stores all over the country. Many loved the convenience but hated that the small local merchants were forced out of business.
The stock market climbed to new heights in the late 1920s, the ordinary American was encouraged to invest their savings in the stock market and more Americans owned stock than ever before. At the same time the proportion of Americans on incomes below the poverty line continued to increase so that this proportion reached almost 50% by 1929 by some accounts.
Campaign finance was out of control with large companies like Dupont and General Motors giving lavish contributions to both parties. In a magazine called “The Forum”, in a July 1929 issue, a man called Norman Thomas wrote an article called “Plutocracy in the Saddle” about business domination of government and calling the two party system the Tweedleduplicans and the Tweedledeemocrats. He also went on to say about this system of two parties in the pockets of big business “This is immensely better than having one dictator who might get shot or one party which might provoke a rival organization based on principle. Two parties to stage a good show annually and a roaring circus every four years to divert the people – what could be better? … A devout and reasonably shrewd “captain of industry” who does not daily thank God for this great gift of two parties, both his for the campaign contributions, is an ingrate. … Indeed its more sophisticated leaders may sometimes reflect how much better it is to teach people how to read and then give them what they should read, let them vote but control the parties through which they vote, [rather] than, like the stupid Czar of Russia, to try to keep the masses illiterate and voteless.”
In the latter half of the 1920s the Public Utilities were consolidating like crazy through a handful of holding companies, and in the process were raising consumer prices. As people found out later they were also taking on huge amounts of debt, overvaluing assets and hiding losses from investors.
Corporate profits were soaring throughout much of the twenties generally thought to be due to increased consumer spending, credit availability and increased efficiency.
But there was a large part of this story not being told lest it would offend the advertisers providing the revenue to the radio stations and newspapers. This was that of the conditions and wages of the non-union workers in the many factories – such as garments, candies, and so forth. In general union membership declined drastically during the 1920s.
There were sweatshop activists in those days too. You can find some of their reports online at the Library of Congress website. In one report by the Consumers League of New York entitled “Behind the Scenes in Candy Factories” you can read about the appalling conditions of women who worked in these factories and the wages of around $10-12 a week, which was considered well below a livable wage. The authors actually went to work in these factories in order to learn about these conditions. There were also reports documenting abuses in the garment industry and a campaign to encourage labeling of garments with the conditions they were made in. This was all in stark contrast to the glamorous images of these products portrayed in never ending streams of advertising.
A network of consumer activism popped up around the country much of which was spearheaded by a Nader-type by the name of Stuart Chase. In 1927 he co-authored a large study called “Your Money’s Worth” documenting the shoddiness of many mass-produced products, the false claims in advertising and the trend for producers to make sure products would be replaced at frequent intervals. Comparing the consumer to Alice in a nonsensical Wonderland he found advertising industry correspondence with corporate clients that boasted that only 25% of purchases are based on real need – the rest are the product of “salesmanship”.
On the financial side, Andrew Mellon was Secretary of Treasury for the whole decade. He was also one of the original founders of ALCOA – the Aluminum Company of America – exactly where our Treasury Secretary of 2002 – Paul O’Neill – is from. And O’Neill is spookily sounding a lot like his predecessor of the 20s!
A fellow named Benjamin Strong, a Morgan man, was the Director of the Federal Reserve Bank of New York at the time. His informal and totally private agreements with the head of the Bank of England, Sir Montague Norman, to help England stay on the gold standard led the Federal Reserve to make harmful interest rate cuts in 1927 that created excessive stock market speculation. This played a large part in the severity of the ultimate crash. This dealings between Strong and Norman are documented in the diaries of Federal Reserve Board member Charles Hamlin which are also readily accessible on the Library of Congress web site.
The British economist John Meynard Keynes was very critical of this move of England back to the Gold Standard saying that “In truth, the gold standard is already a barbaric relic.” This is because the gold standard forced prices and wages to be set by international traders and speculators, rather than the needs of workers and consumers. Today, these are still set by international speculators in our current environment of free capital flow and domination by a single reserve currency – the USD.
This move by the Federal Reserve in 1927 to lower interest rates to help England stay on the gold standard encouraged stock speculators to borrow money at these low rates from the banks and then plow these borrowed funds into the stock-market. The banks themselves were engaged in a lot of these speculative activities because many of them also operated investment banking and brokerage businesses. This speculation continued until 1929 when in August the Federal Reserve raised interest rates.
Stock prices reached their peak in September – the Dow Jones Index having doubled in just over a year. But then with the higher interest rates on borrowed speculative funds and nervousness that stocks were overvalued, stocks started falling in October. Banks started calling in the loans used to buy stock. On October 29, 1929 (Black Tuesday) the Dow-Jones Industrial Index crashed enough to wipe out this doubling of the Dow. The Dow and the markets as a whole started on a downwards spiral that bottomed out in 1932. Many people just couldn’t pay off their loans and banks started going bankrupt all over the place from this and from the collapse of their own stock investments. There was at this time NO Federal Insurance of bank deposits and people saw not only their stock markets investments disappear, but also their bank accounts vanish. For, even under the gold standard, bank money is nothing but the confidence that it can be used in trade. When that confidence disappears, so does money, and so does everything you worked for and transferred into those mysterious make-believe credits. If you need to refresh you memory about why money is simply an abstract notion and how it comes into existence – you can revisit Wizards of Money Part 1 entitled “How Money is Created”.
America was still on the gold standard. So compounding all these problems the massive loss of confidence in the banking system caused the worst thing of all for the financial system – a run on banks – with people wanting to redeem their bank deposits and Federal Reserve Notes for gold. But of course there isn’t enough gold under fractional reserve banking and such a run on banks will always collapse it. Expectation of bank collapse is a self-fulfilling prophecy, as it is with the stock markets, and as it is with any currency.
When you have such lost confidence in the financial system, where there has just been complete dependence on it, the whole monetary system collapses – money disappears because all it was was confidence anyway. Everything – markets, trade, business, work – it all starts to grind to a halt.
The financial house of cards collapses. And should we be afraid of what is – well, just a pack of cards?
Excerpt – Alice and The Pack of Cards
Herbert Hoover was President at the time of the 1929 Crash. In the subsequent depression neither his administration nor the Federal Reserve did very much to bring the country out of the depression. This helped to get FDR elected and he took office in 1933.
As history goes whenever a famous leader says something really important about big business it doesn’t get remembered very well. Instead the large corporations who run the networks seem to have an uncanny knack of extracting only the short phrases that don’t hurt revenues and playing them over and over again so that nobody will remember the important things that were said about their advertisers.
And so it was with the FDR inauguration speech of 1933 where every man and his dog remembers:
“The only thing we have to fear is fear itself”.
But how many people remember the other parts of the speech where FDR is talking about the bankers and the Wall Street speculators? Such harsh criticism of the Wizards has never been heard since from an American President!
I will play excerpts from this speech about the Wizards, but since the sound recording quality is so poor I will then repeat these sections.
Excerpt from FDR 1933 Speech:
“ And yet our distress comes from no failure of substance. We are stricken by no plague of locusts. Compared with the perils which our forefathers conquered because they believed and were not afraid, we have still much to be thankful for. Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply.
Primarily this is because the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.
True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They only know the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.
Yes, the money changers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.
Happiness lies not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort. The joy and the moral stimulation of work no longer must be forgotten in the mad chase of evanescent profits. These dark days, my friends, will be worth all they cost us if they teach us that our true destiny is not to be ministered unto but to minister to ourselves and to our fellow men.
Recognition of the falsity of material wealth as the standard of success goes hand in hand with the abandonment of the false belief that public office and high political position are to be valued only by the standards of pride of place and personal profit; and there must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing. Small wonder that confidence languishes, for it thrives only on honesty, on honor, on the sacredness of obligations, on faithful protection, and on unselfish performance; without them it cannot live.”
“And finally, in our progress toward a resumption of work we require two safeguards against a return of the evils of the old order; there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people’s money, and there must be provision for an adequate but sound currency.”
And so the process for implementing regulation to provide checks and balances and bounds on the markets began. For it is only after such a collapse that the Wizards actually realize that their success in their own game does ultimately depend on the people’s willingness to play in it. The regulatory blitz included all the landmark laws described above plus many more. The regulations, of course, started first and foremost with the Rulers of the Exchange of Mankind’s goods and the Money Changers in their Temple.
The 1933 Glass-Steagall Act built a wall between banks – which are essentially the guardians of the publics money and the brokers and investment banks – who are the primary gamblers in the exchanges. This would prevent privileged bankers from gambling with other people’s money to make profits for themselves. Glass-Steagall also separated these institutions from insurance companies who took on a completely different set of risks.
To restore confidence in the banks and therefore rebuild the monetary system 1933 also saw the birth of federal deposit insurance under the FDIC or the Federal Depository Insurance Corporation. This insurance would guarantee that depositors would get all or most of their money back in the case of bank insolvency. It was realized that this insurance created a moral hazard for banks. Because deposits were backed by the Federal Government banks had more of an incentive to take more risks. They could get more deposits by promising a higher return to depositors. With this money they could invest in riskier higher return assets to get higher profits and the depositors wouldn’t be too worried about this because they knew there was federal insurance on their deposits. This realization brought in a law that forbade paying interest on checking accounts so that banks couldn’t do this. The separation of banks and other financial operations under Glass-Steagall also helped to prevent this undesirable risky behavior of banks.
Now let’s fast forward to 2002 …
5. The Gambling of the Guardians of the Public’s Money
Glass-Steagall protections from bankers gambling with the public’s money are gone. The restrictions on attracting deposits by paying interest on checking accounts are gone. BUT the FEDERAL INSURANCE and ASSOCIATED MORAL HAZARD are STILL WITH US.
It is very interesting to study the memory loss that became evident during the final 1999 repeal of the 1933 Glass-Steagall Act that had built a wall between banking and speculation to protect depositors. It must be noted that Glass-Steagall had already been worn down to a low level of effectiveness. In years before 1999 financial and legal craftiness had exploited every loophole possible to circumvent Glass-Steagall. Regular deposit banking and lending, brokerage, investment banking, and insurance were already overlapping by 1999 but this was still within certain bounds imposed by Glass-Steagall.
When the Gramm-Leach-Blily Act kicked out Glass-Steagall it enabled the formation of financial holding companies that could have interests across the spectrum of finance. The walls between the important public service of credit creation and safe storage of deposit moneys, and the speculative activities of brokerage and investment banking, were torn down. Not as far down as they were in the 1920s … but getting there very fast.
The death of Glass-Steagall enabled the formation of the financial holding companies Citigroup and JP Morgan Chase, among others. Citigroup formed with the 1999 merger of Citibank and Travelers, who also owned the global investment banking and brokerage giant – Saloman Smith Barney. JP Morgan Chase & Co. formed with the 2000 merger of investment banking/brokerage giant JP Morgan and regular banking giant Chase Manhattan. These are the largest banking institutions in the United States, and their deposits are backed by the US taxpayer.
In the Savings and Loans Debacle of the 1980s that followed deregulation of Savings and Loans we learned very well what happens when you combine Federal Insurance of deposits, with deregulation of the investment activity of banks. The bank is, in essence loaning out these deposits to make these investments for their own profit. In this case this often involved over-priced speculative, and even make-believe, real estate. The depositors weren’t so worried about the risks – the banks offered the potential for nice returns and well, the deposits were federally insured. But when the asset side of the bank is too risky, or maybe even make-believe, there is little backing for the deposit moneys which people think are safe and sound. These moneys actually did disappear, just as in the Great Depression, due to the risky investments made by banks in what turned out to be worthless investments. But because of the Federal Insurance on the deposits in the Savings and Loans Debacle, the US taxpayer took on the responsibility of making sure the depositors got their money back.
BUT now we enter the 21st century with two financial giants – JP Morgan Chase and Citigroup – as busy as ever and the walls between safety and soundness in the monetary system, and gambling in the equity markets, fading into the distance.
This is the BIG LEAGUES now, and only time will tell what will happen.
True, financial conglomerates must hold a separated set of assets against their banking deposits – i.e. the public’s money – and they have what is known as risk-based capital requirements on those assets. This basically means that they hold an extra safety net of safe money and this safety net is commensurate with the riskiness of the bank’s investments.
BUT – and here is the big BUT that nobody seems to be noticing or worried about. Under the new rules being set by the G-10 group of Central Bankers at the Bank for International Settlements in Basel, Switzerland – for the first time since capital requirements came in after the S&L debacle – large banks will be able to set these capital requirements for themselves within the next few years.
Capital levels or safety nets of banks will be essentially self-regulated!
These new international bank supervision standards are called the Basel Capital Accords and I spoke extensively about them in Wizards Part 2 on Financial Risk Transfer. Since that episode came out the banks have managed to gain even more ground in their desire for self-regulation because the public has taken absolutely no interest in this issue, even though it effects the safety of all our bank deposits. And it’s not as if all this is secret either – the goings on have been posted to the Bank for International Settlements web site at www.bis.org for years. I think it’s just that its hard for people to understand. It must be admitted that the Basel Accord is not an easy read! I will cover these recent and important developments in Basel at the Bank for International Settlements in later editions of Wizards. While some concerned European citizens have picked up on this tremendous development in bank “un-supervision” this issue remains entirely muted in even the progressive and independent press of the country that produces the world’s reserve currency – the United States. Again I suspect its because people don’t understand it. It’s difficult to appreciate such money issues when you’ve never been exposed to a financial collapse or a monetary attack as most other countries have in the past few decades.
While you ponder the implications of self-regulation of the institutions we deposit our money in at a time when they can both be banks and be gamblers, please also consider the revelations of bank activity made during the Enron Scandal.
The Wall Street Journal reported on Tuesday January 15th that the SEC is investigating the role of Citigroup and JP Morgan Chase in financing so many of Enron’s risky activities and secret partnerships. They are examining to what extent these banks help set up the partnerships and the lack of disclosure the banks presented about their involvement. So far we know that JP Morgan Chase has almost $3 billion exposure to Enron and Citigroup has disclosed over $1 billion exposure but others suspect there is more. Yet not all the deals between Enron and the two banking giants, particularly derivatives positions, have been fully unraveled and quantified. Other banks that were also involved in the riskier securities or derivatives deals with Enron and their secret partnerships were Bank of America, CS First Boston, Deutsche Bank and BNP-Paribas. In particular JP Morgan Chase, Citigroup, CS First Boston and Wachovia were involved in the financing of one of the most controversial secret partnerships of all – the LJM partnerships – headed by Enron’s CFO Andy Fastow and as reported on January 14th in the Wall Street Journal. GE Capital was also involved in this but they are not a federally insured bank … and they are also not very much regulated because of this.
A professor at the University of San Diego is quoted in the January 14th Wall Street Journal article as saying “You can’t do sophisticated limited partnership and credit derivatives without the participation of the major banks”.
A so-called sophisticated banker might say that this concern about banks self-regulating the level of their own safety net is ridiculous because banks have built sophisticated risk management models to help them manage their risks in an optimal fashion. Indeed the leader in building these sophisticated risk management models is JP Morgan Chase who built the widely used and distributed RiskMetrics system for managing financial risk. Wait! Then one opens the January 21, 2002 issue of BusinessWeek only to find an article entitled “The Perils of JP Morgan – Enron, Argentina, Bear Market – A Year after the merger with Chase the bank is racking up losses”. The old JP is in trouble from extensive exposure to failed internet companies, teleco companies, Enron and various foreign gambles. OK – so how well is this popular self-regulating risk management software working? It doesn’t sound good.
Great! Where does that leave the depositor who thought his/her money was safe. Where does that leave the taxpayer who would have to foot the bill if one of these banks got in trouble? Or what if the unthinkable happens – that the gambling activities of the banks cause such a huge loss in confidence that bank money disappears like it did in the 30s and there isn’t taxpayer money to bail out the banks.
The last scenario might be considered a stretch in this day and age because we are not on the gold standard like we were when the Great Depression got underway. Roosevelt abolished gold convertibility in 1933, and the gold standard was only used after that to set exchange rates with other countries until 1971, when gold disappeared altogether from being a money standard. Without anything real backing money, and with the USD as the reserve currency of the world, the argument goes that if we ever had another panic like 1929 the Fed could pump liquidity into the markets as needed. This means that the Fed can make money up (as we spoke about in Wizards Part 1) as needed to avoid massive default on bank loans and the collapse in bank investments that can make banks go under and people lose their deposits.
But there is no guarantee that this will work. If confidence in the markets and the banks is lost to a large enough extent, the whole system may very well collapse, even though, actually BECAUSE, the credits that make up money are 100% make-believe – the system only works because people have confidence in it. Expectation that the system could fail is a self-fulfilling prophecy.
OH, And there is one more thing that exists now that didn’t exist in previous near collapses of the US Banking system – such as the S&L debacle, the 1987 Market Crash, and the Long-Term-Capital-Management collapse of 1998. This new thing is the called EURO, the currency of the European Union – and it gives people somewhere else to park their money if they decide the US banks have gotten too risky. It also gives countries another reserve currency option, and some are starting to take it.
The moral of today’s story then…
Think carefully before you bank on the safety and soundness of the US banking system. Oh, and maybe start planting some vegetables in your backyard.
That’s all for Wizards of Money Part 10. Please note that the Wizards of Money has a web site located at www.wizardsofmoney.org
