What Caused the Panic?
By David Henderson
In one of his posts today, Bryan asks us to consider Scott Sumner’s thoughts in response to an earlier post by Bryan. (BTW, like many of the other bloggers, I’m now hooked on reading Sumner’s thoughts. He has that perfect combination of thinking, knowledge, and tone that many of us strive for.) Here are my thoughts. They relate to points made by two of the commenters on Scott’s post, Bill Woolsey and Greg Ransom.
First, Woolsey pointed out that Scott Sumner needed to make clear which panic he was talking about. In his comments, Woolsey writes:
I don’t know what Caplan meant, but when I read the original exchange, I think you were way to quick to interpret “panic” with the stock market rather than with the financial problems that occurred before. You know, the difference between LIBOR and T-bills jumped by 300%. Crisis!!! The Great Depression is coming if we don’t bail out Wall Street. No one is goign [sic] to be able to get any loans. No car loans. No loans for small business. So, Congress needs to let us borrow $900 billion to jump start the market for mortgage backed securities. That panic.
Not the rapid drop in the stock market that happened next.
That’s what I remember as the panic too. And among those who panicked were Messrs. Paulsen, Bernanke, and Lazear. As I wrote on September 28:
On a Sept. 23 White House conference call, Lazear told listeners that what really led to the belief in a bailout was credit market conditions the previous Thursday, Sept. 18. Credit markets, he said, had frozen. I asked him how he could make strong conclusions about the future of the economy based on data from a day or two. His answer was that the negative returns on short-term Treasuries were scary.
As for the stock market crash, commenter Greg Ransom has a plausible explanation:
I recall one other tiny little bit of news — about Obama taking a commanding lead in the Presidential polls. In late Sept. 2008 McCain “suspended” his campaign, then “unsuspended” it, and his poll numbers dropped like a rock, after coming neck and neck with Obama after McCain’s Palin VP nomination.
Scott Sumner responds to Ransom as follows:
Greg, Good point. Unlike some of the other factors we have very accurate data on the impact of presidential elections. A win for Democrats knocks about 2% off stock values. I imagine that the odds of Obama winning rose by less than 50 percentage points in late September, meaning that the negative impact (although real) was less than 1 percentage point of stock values.
But there’s a large problem with this response. Scott Sumner is generalizing from past data on Democrats rather than reasoning on the basis of this Democrat, Obama, and his plans. Maybe the market anticipated just how much he would try to expand government. One could argue that the market couldn’t anticipate that, but Scott can’t reasonably argue that. In that same post, he writes:
You can be sure that by the time we read that the Baltic shipping rates have plunged 90% (which I recall was in the papers last fall) the markets already knew about it.
In other words, markets are good at incorporating data very quickly.
How do the two connect? By lobbying for huge government discretion, Bush destroyed what little was left of the credibility of the small-government contingent in the mainstream Republican Party. The House Republicans and some Democrats held off the bailout on the first vote in late September and then caved on the second vote in early October. That signaled that there was even more running room for Obama.