Panic or Crisis?

Is Senator Phil Gramm right that economic turmoil is all in our heads, a sort of panic, or are there real problems, suggesting instead a crisis? More generally, how should the current US economic situation be described?

Some descriptive financial terms have fairly settled definitions, although exact classifications can remain contestable. For example, a recession, formally two successive quarters of negative growth, is rarely recognized until an economy is in one. At present, economists are split on whether the US economy is in or near one. A bear market, formally a 20% decline in general equity market prices, is easier to measure, and under that measure, US stock markets are in bear territory (indeed, price levels are not much higher than they were a decade ago).

The terms panic and crisis seem less susceptible to formal definition. Financial panic generally signals an irrational response to perceived economic conditions while crisis, which can include the results of panic, tends to connote a more substantive condition in which structural, cyclical or other forces pose actual acute financial adversity.

In credit markets, crisis probably describes some of the episodic bouts of liquidity contractions seen since last August, probably shown in Citigroup’s difficulties last October In productive markets, the kinds of economic adversity that face titans of US industry, illustrated especially by General Electric and General Motors, show substantive ills fairly within those suggested by the notion of crisis.

Panic is a nominated culprit in the run on IndyMac last weekend. In this view, irrationally nervous depositors aggressively withdrew funds from the bank, resulting in the largest US bank failure in two decades. Panic may be apt to describe anxieties associated with the perceived fragility of Freddie Mac and Fannie Mae, cornerstones of the US mortgage funding system, whose balance sheets on their face do not appear to expose them to risk of capital evaporation.

Prevailing economic turmoil occurs despite what some say are reasonably resilient economic fundamentals. These include continuing productivity gains, steady if shaky general employment levels and overall price stability despite large increases in oil prices and galloping prices of some other commodities, especially agricultural products. Strife amid such un-alarming background conditions suggests panic.

Undeniably, however, at a more macro level, the US trade deficit continues to hit record levels, the US dollar remains anemic by historical standards and the federal budget deficit is astonishingly high, particularly for a Republican administration. These may be ingredients to suggest a legitimate substantive financial crisis, not mere panic alone.

Implicated in a discussion of classifications is who or what’s to blame. The run on Bear Stearns in March may have been sponsored by short sellers. But these may either have been rationally responding to a crisis or orchestrating a manipulative panic. The run on IndyMac may be due to irresponsible statements of Senator Charles Schumer, inducing a panic, or to bad regulatory oversight of which the Senator was being critical, a substantive crisis situation.

At stake in an accurate description is how official responses are likely to influence outcomes. The Federal Reserve is injecting capital into the financial system in unprecedented ways, lending to non-depository institutions, including investment banks and other financial intermediaries. Such direct federal intervention in private markets, along with the more subtle but widely-publicized federal hand in helping Citigroup in October and killing Bear Stearns in March, may either calm or heighten anxieties, depending on whether dominant sources of the situation are best described as panic or crisis.

Regulatory policy is thus also at stake. Panic or crisis, some say all this economic turmoil is evidence of a decline in US capital market competitiveness, largely attributable to over- regulation, epitomized by the Sarbanes-Oxley Act of 2002. Opponents challenge that view by reminding advocates of financial scandals like Enron and Arthur Andersen and other anti-investor propensities of some US executives. Debaters dispute whether lending to sub-prime credits was irresponsible or responsible and related oversight lax or not. Yet even the terms of such debates cannot easily distinguish real substantive challenges associated with crisis from mere perceptions of challenges associated with panic.

So these issues should figure heavily in the coming election. They may favor Senator Obama over Senator McCain. If there is a crisis, the populace likely will blame the incumbent, President Bush, and his party, the Republicans, which will hurt Senator McCain. That may explain why Senator Gramm, a McCain backer, portrays the situation as panic, a “mental” recession plaguing a “nation of whiners.” Yet, ironically, that classification may backfire. A standard cure for pessimism is optimism and that call resonates with Senator Obama’s campaign of hope.

Politics aside, there are real issues in this complex situation, far too complex for any blog post or person to unravel. For our part, my colleagues and I at The George Washington University Law School are planning a conference on the broad subject. It will be held over several days in April 2009 in Washington and will open with the Law School’s 28th Annual Manuel F. Cohen Memorial Lecture. Conference organizers, led by Larry Mitchell as Chair, include

Theresa Gabaldon , Susan Karamanian , Dalia Tsuk Mitchell , Art Wilmarth and me. Tentative title? The Panic of 2008. But that choice may or may not reflect anything suggested by this post!

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3 Responses

  1. Fraud Guy says:

    Undeniably, however, at a more macro level, the US trade deficit continues to hit record levels, the US dollar remains anemic by historical standards and the federal budget deficit is astonishingly high, particularly for a Republican administration.

    You should just delete that last phrase. It is not necessary, and seems to imply that you expect Democrats to create deficits, not Republicans. In my political lifetime, it has been the Republican administrations who have increased the deficits, so you may wish to change it to “, which is typical for a Republican administration.” Or you could just delete it to be seen as apolitical instead of partisan.

  2. Lawrence Cunningham says:

    Fraud Guy: I have no objection to the suggested deletion.

  3. Larry,

    Great post. This is an important topic. I am glad to see nuanced analysis.

    Regarding the above phrase, Republicans have long cultivated an image of fiscal restraint, even if the last three decades have exposed it as just an image. I got your drift. Fraud Guy’s comment is enough of a corrective. bh.