The Recession and Banking Crisis: We’ve Been Here, Dozens of Times

So much has been written about the recession that befell the country in the late summer of 2008. It was “unprecedented;” it “caught experts by surprise;” “virtually no one saw it coming.”

After all, a recession triggered by a major segment of the economy that was vulnerable to speculation, occurring during a time of high government deficits, cuts in interest rates, and tax reductions combined with dramatic increases in federal spending? When has that happened before?

“Dozens of times, if not more, during the last one hundred and fifty years or so,” says Richard Grossman, professor of economics, economic historian and author of the new book Unsettled Account: The Evolution of Banking in the Industrialized World Since 1800 (Princeton University Press).

“The collapse we just experienced wasn’t unforeseeable,” Grossman says. “It’s just that, right up until the summer of 08, everything seemed pretty good on the surface. When times are good, not many people are looking for disaster.”

Grossman pauses, then smiles.

“Well, not many people except for economic historians.”

The economic crisis that led to the recession is only one of the reasons Grossman decided to write Unsettled Account (See video below). Economic crises precipitated by the banking industry are not new and or unique to The United States. His book covers the history of the industry during roughly the last 200 years, drawing examples as well from England, Australia, Japan, Canada and Western European countries.

[youtube width=”640″ height=”420″]http://www.youtube.com/watch?v=e0dwxJayc4g&[/youtube]

“I wanted to write something that was accessible to the curious reader,” Grossman says. “This not only gives a good history on the banking industry in this country, people will be able to see how ‘bubbles’ similar to the housing bubble have burst and affected economies in the past. I also wanted to format it in a way that showed the typical cycles involving these types of crises.”

The book is divided into four sections: Crisis, Bailouts, Mergers, and Regulations.

Grossman points out that scenarios very similar to the one we just endured could be found in the U.S. in the 1860s-70s with railroad speculation, or in the late 1800s in British banking system when land speculation in Latin and South America got out of hand, or in the late 1920s and early 1930s with stock speculation.

“Once the crash comes, then there are the debates about government intervention and bailouts and whether that’s warranted,” he says. “While those decisions are being made, the push to tighten regulations becomes more heightened.”

The regulation phase, which we are going still going through, is always intriguing because no matter how comprehensive the measures enacted are, efforts to find ways around them are always more vigorous.

“It’s not that the regulators aren’t smart, it’s that the profit motive, and the incentive for reward among human beings in general, is so strong, that the marketplace will always find ways to subvert the regulations. It’s just a fact of life.”

However, this is not always a bad thing, Grossman says. For example, in the 1970s, U.S. bank regulators had set a very low ceiling for interest on savings and checking accounts. The banking industry felt there was more money to be made in that sector, especially over the short-term, and responded to the regulations by creating the certificate of deposit (CD). It was a controversial move when it first occurred, but now CDs are ubiquitous and embraced by the industry, the public, and the government.

Sometimes, however, regulations create unintended consequences.

“During the same period, regulations on U.S. banks stipulated that certain amounts of reserves had to be kept on hand for doing business. The banking industry responded by taking that business, specifically loans and other types of financing, overseas to Britain, Switzerland and other countries where the cash reserve requirements were much less stringent. The result: a tremendous loss of business here and a rapid increase in those types of transactions in other countries, as well as a rapid expansion of other ‘offshore’ banking activities.”

The book holds other examples of bubbles, busts, regulations, mergers, as well as suggestions for ways to avoid more collapses in the future. While Grossman doesn’t want to give everything away he does say that his recommendations include greater harmonization of regulations and a heightened emphasis on risk acceptance by speculators.

“There’s nothing wrong with speculation in general, but when the rules have been set up so that the speculators have to put very little up front, they can fail spectacularly – especially the bigger entities – and then they are bailed out, and they repeat the process. It sets up a fertile ground for a big bust,” Grossman says. “Let the entrepreneurs and investors and banks and others speculate. Just make them assume much more of the risk up front when they do. This will make them work harder to take smarter risks and lessen the unintended consequences for failure. If you don’t create mechanisms like this and a few others, well, as the book shows, history has all kinds of examples that can wreak havoc not just on certain sectors of the market, but on the entire economy of countries in ways that can take years, if not decades, to recover from.”

Grossman’s thoughts on more immediate events in the economy can be found in his blog, also titled Unsettled Account.