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The Descent of Finance

DBR | 1호 (2008년 1월)
When today’s great crisis ends, the U.S. financial system will be a shadow of its former self, but America will be stronger than ever. History shows that money and power don’t always go hand in hand.
If the ascent of modern finance began in the 1980s, with “liar’s poker” on Wall Street and the City of London’s Big Bang, it ended on September 15, 2008—the day Lehman Brothers Holdings went bankrupt. Seven years on, 9/15 supplanted 9/11 as the costliest day in Wall Street’s history.
Lehman Brothers’ demise was one of seven events that, in the space of just 19 days, signaled the end of an epoch. The first, on September 7, was the nationalization of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). On September 14 Bank of America announced that it would buy Merrill Lynch. On September 16 a money market fund, Reserve Primary, broke the buck—that is, its net asset value dropped below $1 per share—because of losses on the unsecured commercial paper it had bought from Lehman. That same day the Federal Reserve agreed to give AIG $85 billion to avoid a lethal chain reaction if the insurance giant couldn’t meet its obligations on the credit default swaps it had sold to banks. Nationalization in this case took the form of a warrant to the Federal Reserve for 79.9% of the company’s equity. On September 22 the investment bank became an extinct species when Goldman Sachs and Morgan Stanley converted themselves into bank holding companies. Finally, on September 25, Washington Mutual Bank was seized by the Office of Thrift Supervision and placed into the receivership of the Federal Deposit Insurance Corporation—marking the biggest bank failure in America’s history.
Although the crisis began nearly two years ago, September 2008 was the month American finance fell off a cliff. What will be the long-term impact on the U.S. economy and the global financial system?
From Crisis to Breakdown
Imagine the worst-case scenario: The current recession turns out to be another great depression. The one that began in August 1929 lasted 43 months, according to the U.S. National Bureau of Economic Research. However, the first great depression, which only historians now remember, began with the Panic of 1873 and lingered for 65 months. If the U.S. economy keeps shrinking that long, there won’t be a sustained recovery until after May 2013.
Fast-forward to 2013. The government-owned Citibank of America, formed by the forced merger and nationalization of the United States’ two biggest banks, now dominates retail banking. The number of U.S. banks has fallen by half, from 8,534 in 2007. There are just 3,000 hedge funds all over the world—less than a third of the precrisis total. The regulatory framework that was imposed by Treasury Secretary Timothy Geithner in the previous four years has completely changed the financial landscape. With new restrictions on executive compensation, bank capitalization, and derivatives trading, retail banking has become more like a public utility. Even nonbank entities like hedge funds and insurance companies have to operate under the unsleeping eye of the new Financial Authority for the Regulation of Systemic Institutions (FARSI).
Despite FARSI’s extensive powers, the U.S. government is still grappling with the fiscal legacy of the crisis. The federal debt is now around $20 trillion—$3 trillion higher than the Obama administration forecast in its 2009 budget. The top income tax rate is 45%. The S&P 500 is down to 418, where it was in December 1991—a decline comparable to that between 1929 and 1934. The United States, it appears, is stuck in the middle of its own lost decade, with real GDP having grown by barely 1% per annum since 2010.
We started out calling it the Subprime Crisis. It quickly became the Credit Crunch and then the Global Financial Crisis. By 2013 a new name has stuck: the Breakdown.
The breakdown of the American colossus has fundamentally altered the international economic order. China’s GDP in 2013 is half that of the United States; in 2006 it was only one-fifth as big. The U.S. dollar has halved in value against the Chinese yuan following a Russo-Chinese initiative to replace the greenback as the international reserve currency with the International Monetary Fund’s Special Drawing Rights (SDRs, pronounced “sadders”). Oil, for instance, is priced in SDRs.
For the newly elected U.S. president, Jeb Bush, who defeated Sarah Palin for the Republican nomination in 2012, the time has finally come to Put America First. Treasury Secretary John Paulson says he is optimistic about his negotiations with the IMF to repay the 150 billion SDR loan negotiated by his predecessor. An investor in gold mines all over the world, Paulson is enthusiastic about the president’s plan to return the United States to the gold standard. At the G4’s latest meeting, the Brazilian, Russian, Indian, and Chinese foreign ministers unite to condemn Commerce Secretary Lou Dobbs’s latest round of tariffs on imported apparel and automobiles.
Meanwhile, Defense Secretary Max Boot confirms that U.S. “R” (for robot) forces will continue to be deployed in the radioactive zone around Bushehr as part of Operation Iranian Freedom, launched by the new Bush administration to support Israel’s recent strikes on Iran’s nuclear facilities. With unemployment stuck at 12%, many Americans are excited by the military successes in Iran; the Islamic Republic inflicted several humiliations on President Obama’s administration after his disastrous visit to Tehran in 2010. However, people are more nervous about the naval clashes between American and Chinese forces in the South China Sea.
If this scenario strikes you as too pessimistic, think again. From 1929 to 1933 the stock market rallied several times on the long way down to the bottom. In fact, the Dow Jones Industrial Average moved up by at least 2% on 15% of the trading days between October 1929 and December 1932; on 34 trading days it rose by more than 5%. True, post–World War II recessions, on average, have lasted only 10 months from peak to trough, but the present crisis is no average recession.
Back to the 1870s
One hopeful possibility is that this recession will be no worse than the two worst recessions since 1945: those of 1973–1975 and 1981–1982. If that’s the case, a recovery should be under way by the time this article is published. But consider another scenario: Suppose this recession resembles neither the Great Depression of 1929–1933 nor the big recession of 1973–1975 but is more like the Long Deflation of the late nineteenth century. That one began after the financial panic of October 1873 and dragged on until March 1879. Although it was more protracted than the 1930s depression, the 1870s slump was less painful. In 1873, as in 2008, the trouble began with a monetary policy misstep. The government demonetized silver, saying that only gold could be used to back banknotes. The deflationary effects proved unpopular, particularly with indebted farmers. A technological and construction boom in the form of railroads was coming to an end. A major bank failure signaled the beginning of the panic: Philadelphia-based Jay Cooke & Company blew up. There was a sell-off on Wall Street, though it was a steady slide rather than a nosedive. From the peak in May 1872 to the trough in June 1877, stocks slowly declined by 47%. Then as now, the crisis was global, with the American crash coming just five months after collapses in Berlin and Vienna.
The contraction in output was smaller in the 1870s than in the 1930s. In fact, 1874 was the only year during that depression in which U.S. real GDP declined. By 1877 production was 12% higher than it had been in 1872. There were two reasons for this: One, grain production in the Midwest and steel production in the Northeast were both soaring. Moreover, continued growth in the number of banks ensured that money supply didn’t contract. Two, the crisis didn’t lead to the breakdown of globalization. Many countries raised tariffs in the late 1870s, but they didn’t impose restrictions on capital flows or migration. Trade wasn’t significantly impeded; indeed, it received a boost as railroad lines were further extended and oceangoing steamships became more efficient. Nor did foreign investors lose their appetite for U.S. bonds and stocks.
A long deflation like that of the 1870s? A great depression like that of the 1930s? Or a big recession like that of the 1970s? It all depends on what matters more: the burden of debt and falling asset values, or easy-money policies and fiscal stimuli.

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