The Great Shakedown of 2008

From Standard & Poor's:
U.S. Economic Forecast: Another Panic Of ‘07?
The financial markets marked the centennial of the great panic of 1907 by holding another panic. Indeed, this one seems likely to affect the economy less than its predecessor did because the central banks have learned to handle liquidity squeezes better than in the past. The 1907 panic was one of the major reasons for the founding of the Federal Reserve System, as Congress decided that it could not rely on the good will and ability of bankers like J.P. Morgan to coerce cooperation. Will Chairman Ben Bernanke do a better job than Mr. Morgan?

Is it an accident that these crises often seem to occur in years ending in "7"? Financial turmoil struck in 1957, 1967, 1987, 1997, and 2007. It is hard to tell about 1977 because the whole decade was one long crisis (so maybe just having a "7" is the problem). Going back further, 1937 was a bad year, as were 1897, 1907, and, of course, 1917, with America's entrance into World War I.

Although the current turmoil began in the subprime mortgage market, it has extended far beyond that to a general crisis of confidence. What's happening now is a classic run on the bank, except that the banks have been disintermediated by the short-term money markets, which have become a virtual bank. A central bank's role in fighting bank runs has been well established: provide adequate liquidity so that the panic does not bring down the solvent banks. This principle needs to be extended to the money markets that now support the banking system.

Part of what is happening is a reassessment of risk. For at least the last two years, Standard & Poor's Ratings Services has noted that credit spreads were too narrow to justify the risks inherent in the instruments investors were buying. Recent credit problems have usually run their course within about three months, and we expect this one to do the same. However, that does not mean that spreads will return to the extremely narrow range of three months ago; rather, they'll likely stabilize.

We had thought that except for the housing market, the problems would have little effect on the economy. However, the drop in employment in August and the downward revisions to the previous two months of job
data—together with the earlier downward revision to recent GDP—suggest less momentum than we had thought. Consequently, the danger of recession is more severe than we had thought.