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Past Crises Suggest More Waves of Pain

The Wall Street Journal Home Page

Past Crises Suggest More Waves of Pain

July 14, 2008; Page C1

Investors could use a good road map right now.

Just when the credit crisis seems to calm down, it roars back with greater ferocity, bringing ever bigger institutions to their knees. Where is the crisis heading? How bad could it get?

There are some broad answers to these questions. The rhythm of the credit meltdown the past few weeks — the daily drumbeat of falling bank stock prices, the repeated waves of investor relief and revulsion, the multiple rounds of money raising by banks that never seems to be enough — is reminiscent of financial crises past.

Look back exactly one decade — to the Asian financial crisis in July 1998 — for one of many examples of the parallels.


That crisis started in Thailand a year earlier. By July 1998 the Thai stock market had been through several false recoveries. Big banks like Thai Farmers Bank and Bangkok Bank had raised capital from foreign investors but quickly discovered they needed more, making investors more demanding. Thailand was months from seeing the worst of it, and years from fixing its problems.

As professors Carmen Reinhart and Kenneth Rogoff lay out in one of two recent papers on crises, the current one follows “a well-trodden path laid down by centuries of financial folly.”

Crises are often preceded by a buildup of asset prices and borrowing. The “deleveraging” that follows creates pernicious feedback loops — firms reduce debt, selling assets and raising equity, which pushes asset prices lower, forcing them to reduce more debt and sell more assets. It’s probably one reason these things come in waves. A common psychology of denial and acceptance is another reason for the waves, as is the mystery of price discovery in such uncertain environments.

There are a range of historical routes out of a morass. Korea and Thailand in the 1990s reluctantly brought in foreign investors to take stakes in financial institutions. They suffered nationalist blowback in the process. (One outsider investing in Asia at the time, ironically, was Daniel Mudd, then head of GE Capital’s Asian operations. He’s now CEO of Fannie Mae, the struggling U.S. mortgage company.)

Another common theme: The inevitable use of taxpayer money to take damaged assets out of bank hands. Thailand and Korea did it, as did the U.S. in the 1990s when it set up the Resolution Trust Corp. to manage assets of failed savings and loan institutions.

Japan kept troubled banks alive as long as possible, delaying the pain of fully assessing their losses. That led to a lost decade for stocks and the economy, and zombie banks that lacked the capital to lend.

If you bail everybody out, says University of Chicago professor Douglas Diamond, “you’re going to end up in a prolonged stagnation that will give you more losses than if you allowed the whole system to melt down.”

Whatever the policy response, history suggests this won’t be finished soon. New waves of market turmoil and economic pain should come as no surprise.

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