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Understanding the Panic of '08


Panics are just a loss of logic.

The Panic of '08 has nearly every investor convinced that the world is coming to an end. With the financial system shaken to its core, who can blame them? But is the world really coming to an end? Are the "evil doers" on Wall Street getting their just deserts while causing unbearable hurt for the rest of us? Is it time to repent, for the end is near?

At the risk of provoking the dooms-dayers, perhaps a little perspective amidst the chaos can help put the current crisis in context.

For starters, the current credit crisis is principally a financial one, brought about by an ideology rooted in the belief that unfettered markets know best. But along with this adherence to laissez-faire economics are the inevitable booms and busts, bubbles and panics that are more characteristic of the pre-Depression era than the post World War II one when the invisible hand was restrained by the government. When a political pushback emerged in the late 1970s, the force of laissez-faire took center stage again in the form of the Reagan economic doctrine – lower taxes and less governmental involvement. Perhaps you might recall the sarcastic political phrase: "I'm from the government and I'm here to help you".

When the US adopted the Reagan economic doctrine, it set in motion a period of unbridled growth in which the US economy, unshackled from its quasi-socialistic straight jacket, enabled businesses to prosper as never before. Along with technological advances like the Internet, the adoption of the market economy model by formerly state-run economies like China enabled the rest of the world to join the global growth party. So far, so good. But, as with all good things left unchecked, things can, and do, go to excess. The world economy got unchecked when rules and laws changed, many of which came courtesy of Senator Phil Gramm.

Which brings us to the last and reckless phase of this story.

When the government decides to look the other way and neglect its oversight role (CFTC, for example), and when the monetary authorities pump vast sums of money into the economy to address fears of deflation (the Greenspan Fed from 2001 through 2003), the pre-conditions are set for serious mischief. Enter the financial engineers of Wall Street.

We all know the story of financial products that didn't exist a mere decade ago growing to trillions of US dollars in notational value (credit default swaps, for example). We also know that many of these instruments are still hidden in the dark corners of customized OTC products, making "you don't know what you don't know" the deep-rooted instinctual emotion driving the panic of today. Add to this the latest financial wildfire approach of the Fed and US Treasury, the antiquated notion that markets are always efficient (FAS 157, for example), and the bizarre logic of many FOMC members still fretting over inflation. All things considered, it's completely understandable why panic has taken hold.
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