Gee, was that 1998, or 2008? Neither -- try 1825 London.
You might think an era of gas lighting, slow sailing ships and horse-drawn carriages has little to teach us about modern finance, but much of what we consider advanced capitalism has been in place since the 1500s: stock markets, portfolio insurance, options, commercial paper and global banking.
Eerily, many of the conditions that fed the boom of the 1820s and the bust of 1825 parallel the present:
- Emerging economies were opening (South America then, China and India now);
- Expansionary monetary policy and easy credit fueled a stock market boom;
- Infrastructure projects required massive capital and equally massive borrowing;
- Risky/fraudulent "investments" were sold alongside sound ventures;
- Banks' lending discipline and oversight declined in the euphoria, creating bad debt;
- Prices rose, adding to the instability (in our era: oil jumping to $147 a barrel);
- Speculation in overseas and risky domestic ventures ran rampant;
- New financial instruments had been introduced which obscured both risks and returns.
Many analysts point to the prodigious expansion of difficult-to-assess mortgage backed securities and exotic derivatives such as CDOs (collateralized debt obligations, often backed by highly leveraged securities) as the chief source of asymmetric information flow which caused buyers around the world to purchase highly risky assets in the belief that they were high-yielding "safe" investments.
Others point to the ample opportunities for fraud and embezzlement in such cloudy situations -- another parallel with 1825 and indeed, every stock market/credit bubble and subsequent crash.
It is generally overlooked that capitalism in its natural state is highly prone to bouts of credit expansion and euphoric speculation which then lead to financial panics and crashes. The Panic of 1825, for instance, was followed by the panics of 1837, 1847 and 1857. Then next crash, in 1866, was hardly the end of volatility, as the Panic of 1873 was a real doozy, setting off a deep six-year recession in the U.S. The Panic of 1893 is generally considered to have launched a depression, while the Panic of 1907 is widely credited with sparking the creation of the Federal Reserve system six years later in 1913.
Walter Bagehot, the influential editor of The Economist in the 1860s and 70s, held the view that the first task of a central bank during a financial panic is to end the panic. In 1825, after some initial hesitancy, the Bank of England did exactly that by lending money to anyone with just about any sort of collateral -- not just sound assets but even illiquid assets.
This flood of new lending staunched the panic, but the stock market slump and recession lasted into 1826.
Central banks appear to have taken Bagehot's message to heart, as the Federal Reserve and other central banks have slashed interest rates to near-zero and eased lending to banks and financial institutions. The Fed has also taken distressed assets such as mortgage-backed securities as collateral.
The central purpose of the U.S. Treasury and the Fed's interventions has been to prop up the banking system, with the understanding that it was necessary because banks perform the essential services of processing private information (mortgage applications, for example) and monitoring borrowers.
But what the Fed and Treasury have not learned from the Panic of 1825 is that the shareholders and managers of the banks which were saved from insolvency by central bank intervention should suffer the losses which are necessary to encourage prudent lending after the panic has ended.
The Fed and indeed, all the central banks of the major global economies, also failed to understand the chief lesson of the 1825 Panic: that it was fundamentally fueled by expansionist monetary policy.
Thus we have to wonder if the current central banking "solution" -- encouraging lending, lowering interest rates and accepting any sort of distressed asset as collateral -- isn't just setting up the Panic of 2011.
Charles Hugh Smith writes the Of Two Minds blog and is the author of numerous books, most recently Survival+: Structuring Prosperity for Yourself and the Nation.