Vol. 1999-7

Some Thoughts on the Current Boom and Its Banking Implications

   It is not often that I begin one of these commentaries with an enthusiastic endorsement of a book by an economist. I do so now, having just finished reading (more accurately, re-reading) John Kenneth Galbraith’s account of the stock market crash of 1929. Not that his book requires help from me or anyone else; it has been in print continuously for almost a half century, having gone through seven editions or printings (judging from copyright dates) since I read it for the first time in 1955.

  The Great Crash is a slim volume, blessedly free of the devices – such as graphs, obscure footnotes, and mathematical equations -- that economists typically use to make it clear that they are writing only for other economists and that the general public is not welcome. Equally important, it is written by someone with a delightful sense of humor or, what may be the same thing, an eye for the absurd. It has all of the elements of a special kind of thriller – say involving a World War II espionage plot – where the ending is never in doubt but one cannot put it down before finding out “why” and “how.” (Galbraith, The Great Crash,1929, Houghton Mifflin Company, 1997 edition).

  I sought out Dr. Galbraith’s examination of the 1929 crash because, as a few readers may recall, in my last report I had commented on the fact that the failure last year of a small bank in Boulder, Colorado (BestBank) had received virtually no attention in this country but, quite surprisingly, was the subject of a recent major article in an eminent British publication. The writer had suggested that the unusual nature of the failure – BestBank “managed to lose every penny it lent when times were as soft as they could be” – was symptomatic of the kinds of bank problems described by Galbraith in The Great Crash, when the U.S. was caught up in a period of frenzied stock market speculation. The principal characteristic of such a period is a special kind of public mood that Galbraith described as “a pervasive sense of confidence and optimism and conviction that ordinary people were meant to be rich.” They must have faith in themselves, in their business leaders, and in the financial world generally; without this “they are immune to speculative enthusiasms.” Such an attitude “is most likely to break out after a substantial period of prosperity” Galbraith said.

There is no problem deciding how it will end; history is pretty clear on that. As Galbraith put it in The Great Crash, speculation ends inevitably with a rush to unload. “This was the way past speculative orgies had ended. It was the way the end came in 1929. It is the way speculation will end in the future.” Beyond that, however, Galbraith agrees that there is little that can be said with certainty. We simply do not know when such periods of speculation are likely to occur and when they will not.

Nor can we predict whether the end of a particular speculative orgy will be a hardly noticeable “soft landing,” as has sometimes been the case, or whether it will contribute to a major economic depression. For example, there is some evidence to suggest that the famous “Tulipmania” of 1636-37 was not followed by a severe depression, and that the Dutch economy was generally prosperous until the early 1670s. (Kindleberger, Manias, Panics and Crashes, third edition, John Wiley & Sons, Inc. 1996, p.101). There is no question that the stock market crash and our “Great Depression” both came in 1929. However, there is considerable evidence that the economic downturn had begun before the stock market crash. On the other hand, there is also evidence to suggest that the crash contributed in important ways to the depression, already underway, that ended only in 1939.

 It was while I was reading the Galbraith volume and pondering its relevance to the failure of BestBank in Colorado that news arrived of another extraordinary failure. The First National Bank of Keystone, West Virginia, with total assets of $1.1 billion, was closed by the Office of the Comptroller of the Currency on September 1, 1999. The cause was said to be “massive fraud” -- according to the Comptroller’s office, “nearly half the assets claimed by First National Bank of Keystone are phony” (American Banker, September 2, 1999). The situation was not far different, except possibly with respect to the existence or extent of fraud, than the case of BestBank. As I thought about these two unusual situations, I could not help but recall that last year several of the largest banks in this country were faced with heavy losses when it appeared that LTCM, a hedge fund that they had helped finance (apparently on the assumption that its management had solved the ancient problem of transmuting lead into gold), was about to go under. It struck me that it might be useful to take a closer look at all three cases.

Readers know that the most detailed of my reports in recent years dealt with the LTCM bailout (Vol. 1998- 9&10). I have no intention of digging much further into that situation. Nor, except for the need to identify the problems of the two banks, will I devote more than minimum space to those cases. My objective in this report is to consider whether the three cases – surely an odd trio, seemingly with not much in common – offer new insights into banking and bank regulation. It is a brief report, beginning in Section I with comments on the long-running controversy among economists over the value of economic history, as well as the current controversy over whether we are in a rational or irrational state of exuberance. Section II provides thumbnail sketches of the three cases and some reasons why they may be more similar than one might expect. Section III deals with possible regulatory implications and Section IV offers a few concluding remarks.