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Liquidity Crunch: Panic or Squeeze?

By James H. Nolt

Every economic crisis begins with a tightening of credit, but the popular label for this is a liquidity crunch, in part because economists since Keynes (insofar as they concern themselves with crises at all) use his concept of liquidity preference. Keynes, like most economists and finance theorists since, emphasized the defensive aspects of liquidity. However, my polarized political economy recognizes the offensive strategic gains possible from tightening credit.

Consider first the standard accounts: During a boom, a random “exogenous shock” occurs that undermines the confidence of consumers and/or investors. The resulting panic causes a flight to liquidity. Consumers postpone spending in favor of holding larger cash balances. Investors become bearish about most assets, so they prefer to sell assets and hold more cash in expectation of lower asset prices in the near future. Industrial capitalists defer new investment projects until after the storm passes.



The trigger event, the so-called exogenous shock, is something nobody anticipates and nobody wants. It could be a major earthquake, the outbreak of a war, the sudden revelation of major corporate fraud, a severe terrorist incident, or a particularly bad harvest. People react defensively, fearfully, by liquidating assets, cutting spending, and hoarding cash. Such behavior, if widespread, creates a self-fulfilling prophecy. There are too many asset sellers and not enough bullish buyers, so consumer and producer spending declines, slowing the economy and further justifying the pessimism. A vicious circle of growing fear may take hold until some intervention, probably by the government, reverses the decline in confidence. As President Franklin Roosevelt said during the Great Depression, “The only thing we have to fear is fear itself.” An economist could have written that slogan.

The problem for mainstream economics is that potential triggers occur much more often than crises do. That makes the onset of the crisis seem even more random. Economics normally likes to assume that people act in economically rational ways. It also assumes economies tend toward stability and equilibrium, so the cause of a crisis must be some inexplicable (to economists), temporary fit of insanity. From this perspective, it makes sense to call crises “panics.” The convenient thing about this sort of non-explanation is that it lets economists off the hook whenever they do not predict a pending crisis. How could they? They claim to predict economic behavior when people are acting “normally”—in other words, according to textbook rationality. They cannot be held accountable for collective fits of insanity.

My polarized political economy introduces two elements missing from these standard accounts: 1) private power exercised strategically, and 2) bears, a.k.a. shorts, those who “profit from loss.” Bears are not just those who liquidate out of fear of loss. All the historical crises I have studied involve identifiable bears who positioned their assets to profit from a fall. And the biggest of them had the means—by curtailing credit and propagating negative news—to precipitate the crash that would validate their positions. Such bears are acting strategically, like top predators, not panicked lemmings.

As I mentioned last week, I first discerned this possibility while researching my PhD dissertation, which included looking closely at the Japanese financial crisis of 1927. Subsequently I studied other crises to compare the similar elements. The players change, as do the tactics, but the big picture is the same strategic contest of bears and bulls.

The 1927 crisis ended a four-year economic boom on the heels of an enormous earthquake in the Tokyo area in 1923. The devastation and loss of life were immense, but the rebuilding effort stimulated a period of vigorous growth. The world economy was also thriving at that time, termed “the Roaring ‘20s.” Japan’s textile and apparel exports took off, and the country surpassed Britain as the world’s largest cotton textile exporter by the early 1930s, soon dominating the new rayon trade as well. The region was largely at peace. Japan was not yet deeply involved in the ongoing Chinese civil war, and enjoyed good relations with all the major powers, except the isolated Soviet Union. There was no conspicuous or universally accepted trigger event for the crisis. To most of the public, it seemed to come out of nowhere.

But beneath the surface there was a growing polarization and divergence of strategic interests among Japanese business conglomerates, known as zaibatsu. They were bifurcated into the older zaibatsu, and the structurally different, newer, more bullish ones. The older ones were centered on large banks and general trading companies oriented toward international trade. The newer groups concentrated in heavy industries such as chemicals and shipbuilding that depended on tariff protection for survival because Japan was not yet internationally competitive in those products.

The biggest difference was that the older zaibatsu, led by the “Big Four” (Mitsui, Mitsubishi, Sumitomo, and Yasuda), each controlled one of the five largest banks in Japan, along with large insurance companies. They had all the financing they needed within their own groups. The newer zaibatsu, by contrast, had to borrow extensively to finance massive capital investments in heavy industries. And they borrowed almost exclusively from outsiders. Most of the new zaibatsu’s long-term financing came from government-owned development banks that favored their projects for policy reasons, including strengthening Japan’s war readiness.

Yet the capital the new zaibatsu could borrow from government banks was never enough to satisfy their bullish growth plans. They supplemented their capital with call loans from the five largest banks. Those big banks, who distrusted excessive bullishness, would only lend to the new groups overnight loans that had to be renewed every day or loans that could be “called” at the whim of the creditor, meaning the creditor always reserved the right to cancel the loan and demand immediate repayment.

One day, the big banks controlled by the Big Four cut the credit line to their fast-rising competitors and adversaries. They demanded payment; when it was not forthcoming they forced several of Japan’s largest new zaibatsu into bankruptcy. The Big Four profited mightily. Since many ordinary investors panicked, not knowing which banks were exposed to the failing groups, deposits flowed out of scores of lesser banks and into the biggest banks, which were believed to be safe. Within months, these biggest banks doubled their share of Japan’s total deposits from about one-fifth to two-fifths. Furthermore, as many of the new zaibatsu were bankrupted, the Big Four were able to buy their choice of industrial and mining companies at a steep discount, eliminating competitors and enlarging their own groups. By the 1930s, Mitsui, the largest, controlled roughly 300 companies comprising about 15 percent of Japan’s total output. The Big Four together controlled almost half of Japan’s economy, including the lion’s share of its foreign trade.

This triumph was partially avenged within a few years because several of those companies scarred by the crisis aligned with and financed powerful military secret societies, which during 1931-32 launched a campaign of assassinations against several key business and political leaders implicated in orchestrating the crisis. This led to the fall of party government in Japan and a decisive role for the military instead.

Like every crisis throughout history, Japan’s 1927 crash had winners and losers. It was not just a random exogenous event, but the outcome of strategic interaction among contending parties, much like in war. The polarization that primed the country for this crisis was deeply embedded in divergent business interests and strategies, not just irrational panic. Of course, many ordinary people were surprised and panicked by the crisis, just as are refugees and other victims of war, but their panic was not the cause of the crisis, but merely the secondary effect of clashing strategic initiatives. If economists studied strategic contests the way scholars of international relations do, they might have a better chance of anticipating them. Instead they ignore the real conditions that make crises possible.



James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Aimaimyi]

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