Guest Post: Lessons From The 80s: Nothing New Under The Sun

Courtesy of JG

Does anyone here remember the Latin American debt crisis in 1982?   It was a lot like Greece....

In the FDIC’s own words:  “The crisis began on August 12, 1982, when Mexico’s minister of finance informed the Federal Reserve chairman, the secretary of the treasury, and the International Monetary Fund (IMF) managing director that Mexico would be unable to meet its August 16 obligation to service an $80 billion debt (mainly dollar denominated). The situation continued to worsen, and by October 1983, 27 countries owing $239 billion had rescheduled their debts to banks or were in the process of doing so...

Sixteen of the nations were from Latin America, and the four largest, Mexico, Brazil, Venezuela, and Argentina, owed various commercial banks $176 billion, or approximately 74 percent of the total LDC debt outstanding.  Of that amount, roughly $37 billion was owed to the eight largest U.S. banks and constituted approximately 147 percent of their capital and reserves at the time. As a consequence, several of the world’s largest banks faced the prospect of major loan defaults and failure.

http://www.fdic.gov/bank/historical/history/191_210.pdf

Guess what happened?  The Fed started by injecting $600m in “currency swaps,” which were effectively bridging loans that gave Mexico enough hard cash to pay its bills (aka interest payments to US banks) without showing massive end-of-month depletions of reserves on its books.   The Fed deposited dollars in Mexico’s account at the NY Fed, and Mexico gave the US pesos in return, promising to redeem them with dollars at the end of the month.  The use of currency swaps was especially advantageous because they could be done under the radar screen—public reporting of currency swaps was required quarterly, so the emergency loans would not be disclosed for 3-4 months, during which time Volcker hoped Mexico would be able to arrange a more substantial financing package from the IMF.

Incidentally, I took most of this information from a 1987 book by William Greider called SECRETS OF THE TEMPLE: How the Federal Reserve Runs the Country, which I discovered on my Econ 101 professor (and former Fed Vice Chairman and Bill Clinton Economic advisor), Alan Blinder’s Macro Econ course syllabus.  The 700+ page tome chronicles Paul Volcker’s war on inflation in the early 1980s, in what is essentially an attack on the Fed system from the left.  Greider argues convincingly that Volcker held rates too high for too long, which a) transferred vast amounts of wealth from debtors to creditors; and b) raised the value of the dollar in international FX markets to the point where domestic producers could no longer compete, forcing manufacturing jobs to move permanently overseas.  The deflationary environment and extremely high interest rates crushed debtor nations, as well as small farmers/business men who simply could not earn enough to service their debts.

What struck me most about the book, is how words written more than 23 years ago describe vulnerabilities in the system and a questionable Fed playbook that both persist today.  For example, Richard Koo, Chief Economist at the Nomura Research Institute, published a note on 20 April in which he revealed that the Fed is currently allowing banks to mis-mark their books to avoid triggering what he called a “bank inspector recession.”  During the LDC debt crisis in 1983-84 bank examiners were also told to be tolerant.   “Special advice went out to examiners on the handling of agribusiness loan losses and on the rules for declaring international loans past due.  When Argentina fell behind on its interest payments, a special grace was granted...”

Does anyone here remember Continental Illinois in 1984?  It was the original “TOO BIG TO FAIL” bank...

Continental Illinois was at one time the seventh-largest bank in the US. In May 1984, the bank became insolvent due in large part, to bad loans purchased from the failed Penn Square Bank (think mini-Lehman).

Guess what happened?  The Federal Reserve and FDIC decided that failure would destabilize the financial system.  Unable to find a willing merger partner, the FDIC injected $4.5 billion to rescue the bank. Eventually, the board of directors and top management were removed. Bank shareholders were substantially wiped out, although holding-company bondholders were protected. Until the seizure of Washington Mutual in 2008, the bailout of Continental Illinois was the largest bank failure in American history.

Congressman Stewart McKinney popularized  the term "too big to fail" during a 1984 Congressional hearing to discuss the FDIC's intervention.  Congress was talking about TOO BIG TO FAIL in 1984?

In a 1986 interview, an economist at Salomon brothers pointed out that “The growth in credit is nourished by...the willingness of our government to spread an official safety net over a variety of participants which tends to reduce the risk of borrowing.  No large business corporation is allowed to fail.  No large financial institution is allowed to fail...Federal credit agencies that get into trouble are not allowed to fail.  So there is...an official safety net that’s spreading and that is perceived by the market place.” 

The moral hazard inherent in privatizing profits and socializing risk has been well understood by the market for more than 20 years, and yet the system has remained basically unchanged.   The Fed bailout of Mexico ensured that its US-based lenders would get their interest payments and remain solvent.  The ECB bailout of Greece this week similarly saved the French and German banking systems (at least for now).   There are some who criticize the banks that lent to Greece for shoddy due diligence, but history teaches us that chasing the high yields in Athens in spite of the country’s fiscal challenges was probably rational given that there was an implicit backstop from the ECB.   In the broader context, EC President Jose Barroso’s comment that "We will defend the € whatever it takes,” was to be expected. 

If regulators really want to reform a financial system that incentivizes excessive risk taking, perhaps they should start by restricting government’s ability to bail out failed institutions.  It is probably unrealistic to expect government behaviour to change—and given past performance, lenders to Portugal, Spain, California etc. can take some comfort.   But then again: (p. 667) “In American history, fundamental shifts in the economic orthodoxy usually did not occur until after there was a large and painful calamity, a visible crisis like the financial collapse of 1929 or the Great Depression that followed.  The awful consequences from such an experience discredited the prevailing wisdom and suddenly opened the way for new thinking.  It was only after a disaster unfortunately, that most politicians and most economists were able to entertain ideas they had previously dismissed as unthinkable...”