Friday, December 7, 2007

Book Review: The Panic of 1907

"The Panic of 1907", by Bruner and Carr, depicts the monetary panic in USA during 1907, where lack of monetary liquidity, trusts and bank runs come after one another. Due to the lack of liquidity, the stock market has also crashed severely during this period. The liquidity shortage was so severe that the brokerages have to borrow from Mr JP Morgan and the banks such that the brokerages can pay their counterparties and the stock exchange can continue to function.

Overall the book is a very interesting read, especially for those who are interested in monetary economics or the markets. The book is available in NLB.

A short summary of the lessons from the Panic of 1907:

1) For a panic like 1907 to occur, there must be a system-like architecture in place that allows troubles to spread and probably also allow the amplification of these troubles (e.g. self-reinforcing loop). Also, the system may be complicated in the manner that it may be difficult to know the location and the nature of the trouble in the first place.

2) Bouyant growth should occur before the trouble. Bouyant growth lead to excessive optimism and create a demand on the liquidity that may cause strains on the financial system.

3) Inadequate safety buffers are also present as crashes or panics may not occur if there are shock absorbers in place to prevent the trouble from spreading. For example, deposit insurance has prevent bank runs from spreading. (But the point is that we do not know if the shock absorbers are sufficient or even necessary until a crash. There is a cost in setting up and maintaining shock absorbers.)

4) Adverse leadership may be present during shocks/crashes. The book explains that the actions of political and economic leaders may increase the risk of crisis.

5) There is a real economic shock to the system for a 1907-like crash to occur. The shock should be large and costly, unambiguous and surprising.

6) Excessive fear, greed and pessimism are in place.

7) The failure of collectivism or the simultaneous actions by individuals in choosing to run from the crisis (selling stocks and withdrawing money from banks) so as to save one's wealth first may lead to decreased overall net worth for all and increased chances of a crisis. The book further explains this point through the use of a prisoner's dilemma example.

The above points seems to be present in the current subprime issues (except for pt 4, depending on how you look at it). Would the subprime incident lead to a liquidity crash? I don't know.

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