Vol. 2001-1

For many years my wife and I have spent the Christmas-New Year holidays in England. The long flight from Florida to London has always been the perfect time to catch up on back reading, which usually begins with the American Banker for the first several weeks in December. This year I was startled to find in the December 6 issue a report that Fed Chairman Alan Greenspan had "warned bankers and regulators that overreacting to a slowing economy and deteriorating asset quality could spur a credit crunch." This was an abrupt departure from what we had been hearing for many months: that the economic slowdown and the decline in credit quality called for greater caution by lenders, particularly banks.

As it happened, the Chairman’s remarks had been given to a banker group on the same day that FDIC Chairman Donna Tanoue held a press conference to discuss the release of some new banking data, and had used the occasion to express again her plea for caution in view of looming credit quality problems. The juxtaposition of these two quite different warnings enabled the reporter to play one against the other, thereby spicing up his article for front-page positioning. In fact, warnings of the Tanoue variety had been appearing with increasing frequency from all regulators, including the Federal Reserve itself. In any event, the term "credit crunch" was what caught my eye. I could not be certain, however, that in this instance it was anything more than an incidental comment by the Chairman, with no special significance intended.

I returned to the States on January 3, to be met with the news of Chairman Greenspan’s decision to lower short-term interest rates by one-half point. He made his announcement in the middle of a market day, rather than at its close, and without waiting for the next scheduled meeting of the Fed’s Open Market Committee. As readers know, the market greeted this action with a burst of enthusiasm that I suppose could be characterized as "irrational exuberance." Others were more restrained.

When a dramatic event of this sort takes place, generating a wide variety of reactions, I have often found that the editors of The Economist can be counted on for a balanced view. So it was in this instance. That Journal is a strong admirer of Mr. Greenspan, and although this was evident in its January 6 issue, featuring the Chairman on its cover, the assessment of his January 3 surprise had a negative tint:

One cannot help wondering if the Fed knows something that the rest of us do not about financial fragility in America. Perhaps some specific, impending, and possibly contagious calamity . . . needs to be headed off. If so, the markets will presumably soon regret their spasm of exuberance. . . and we will soon applaud the Fed’s prompt, not precipitate, action in cutting rates. Barring such alarming possibilities, the Fed’s haste is difficult to understand and even more difficult to defend. (The Economist, January 6, 2001, p. 16)

In its following issue, The Economist was still unable to pinpoint the reason for the Chairman’s earlier move, contenting itself with speculating on a few possibilities. But it concluded by saying that feeling was increasing among observers that "something panicked the usually unflappable Chairman." "Credit policy" the journal said, has "deteriorated rapidly in recent months, both for marketable debt and bank loans. And it is expected to get a lot worse," adding that "whatever danger scared Mr. Greenspan, the market thinks it is not past yet" (Economist, January 13, p. 71-72).

In retrospect, it seems evident that the Chairman’s December 6 warning of a possible credit crunch was both deliberate and serious. Thus I was not as surprised as I might have been when, one month later, his much more powerful signal was released. The possibility of a credit crunch of some seriousness now seems sufficiently great to justify devoting a bit of time to what this could mean for banking public policy. History shows that credit crunches have lasting consequences – for good or for ill. Often they give rise to hasty solutions, sometimes conflicting, with which the nation must then live at some cost.

Of course a credit crunch is merely one manifestation of a serious economic downturn and, by itself, nothing very mysterious. The use of credit suddenly declines for a variety of reasons: a fear on the part of borrowers, of lenders, or both. For the great majority of individuals and businesses, it is the decline in the use of bank credit that is most important. On rare occasions, it is much more than a decline but, rather, a virtual disappearance. Thus in 1933 a House of Representatives report concluded:

. . . Experts advise us that more than 90 percent of the business of the Nation is conducted with bank credit or check currency. The use of bank credit has declined to the vanishing point. The public is afraid to deposit their money in the banks, and the banks are afraid to employ their deposits in the extension of bank credit for the support of trade and commerce. Businessmen and investors are victimized by the same fear. . . We must resume the use of bank credit if we are to find our way out of our present difficulties. (Banking Act 1933, Report to Accompany H. R. 5661, House Report No. 150, 73^rd Cong., p.6.)

The principal solution in the 1932-33 instance was the creation of the Federal Deposit Insurance Corporation. It is not very likely, however, that a credit crunch of similar severity can be anticipated today. My point is only that government reaction to any credit crunch can have profound, long-lasting consequences for banking.

Since the 1932-33 experience, there have been at least two serious credit crunches that resulted in government actions that are still troublesome, or at least debatable. The first of these – the credit crunch of 1937-38 – offers perhaps the clearest picture of the kinds of policy issues thrown up at such times. In that year, a sharp recession caused a sudden reversal of a slowly improving economic recovery. I dealt with this subject in Vol. 1995-7 ("New Battles and Old Battlefields"), drawing heavily on an outstanding paper by Donald G. Simonson and George H. Hempel. ("Banking Lessons From the Past: The 1938 Regulatory Agreement Interpreted," Journal of Financial Services Research, 1993, cited hereafter as "S&H").

Section I of this report deals with the resolution of that crunch. Section II is concerned with another great credit crunch, resulting from the economic downturn in 1990-91, which also has had a substantial and lasting effect on banking public policy. Section III undertakes the risky job of attempting to read the few tea leaves that point to possible public policy changes affecting banking, should another serious credit crunch be in the offing.