There was a whiff of August 2007 in the air last week as financial markets tumbled around the world. More than a whiff, in fact.
The familiar stench of panic was back as shares fell heavily, bond yields in Spain and Italy rose and the search for a safe haven sent the price of gold to a new record level. Banks took an especially severe pummeling amid fears that they were exposed to the two big concerns of investors: a breakup in the eurozone and a double-dip recession in the global economy.
In a week of anniversaries, Thursday conjured up all the wrong sort of memories. It was 97 years since Britain declared war on Germany and the resulting financial turmoil meant the stock market, which had closed at the end of July, did not re-open for business until early 1915. Yet even in the month or so after the assassination of Archduke Franz Ferdinand in Sarajevo, when the great powers gave up on diplomacy and prepared for conflict, the movements in financial markets were less violent than they were on Thursday.
More recently, it is almost four years since an announcement by the French bank BNP Paribas that it was temporarily suspending three hedge funds specializing in US subprime mortgage debt led to financial paralysis. Banks, it was discovered, had lent unwisely, were loaded up with toxic derivatives that were vulnerable to falling US house prices and had far too little capital set aside for a rainy day. On Aug. 9, 2007, the heavens opened.
On the face of it, the banks are in better shape than they were when the British bank Northern Rock became the first major UK high street lender to suffer a bank run since Overend, Gurney and Co in the 1860s. They have been forced to build up capital reserves and to hold a higher proportion of their assets in liquid form — financial instruments such as government bonds that can be quickly turned into cash.
Financial regulators have spent the past four years crawling all over the banks, making up for the not-so-benign neglect in the days leading up to the crisis, when supervision was far too lax. The British Financial Services Authority, the European Banking Authority and the US Federal Reserve know where all the bodies are buried in their respective banks. In theory, at least.
One of the parallels between August 2007 and this month is the shiftiness of those running the show, a sense that they are not letting on all they know for fear of creating more panic.
The dwindling band of optimists point to differences with four years ago. Many companies, especially the bigger ones, are in rude financial health after cutting costs aggressively. Parts of the emerging world, such as China and Russia, are growing strongly and may act as the locomotive for the rest of the world. In the West, interest rates are low and budget deficits high: Policymakers have pressed the pedal to the floor in an attempt to get their economies moving.
However, the ultra-loose state of macroeconomic policy cuts both ways. Policymakers were the heroes of Meltdown 1, thumbing through their copies of Keynes’ General Theory to come up with the measures deemed necessary to prevent the global banking system from imploding.
However, if the next few weeks see Meltdown 2, the policy options will be limited. Interest rates are already at rock-bottom levels, while the flirtation with Keynesian fiscal policies was brief. As one analyst put it last week, the monetary and fiscal guns are not obviously full of bullets. Thursday’s mayhem will fan speculation that the Federal Reserve will respond with a third dose of electronic money creation through the process known as quantitative easing.