How do financial crises end?

At the time of this post the Dow Jones Industrial Avg. is down over 300points. Yesterday Former Fed Chief Alan "irrational exuberance" Greenspan called the current situation a Credit Tsunami. (See video below) The economic condition cannot be overstated, and investors big or small are calling for strategies that truly speaks to the economy.

Chamber Member Wyn Yelin Financial Advisor, UBS Financial Services Inc. offered the following anecdote :

Like forest fires, there are essentially two ways of dealing with financial crises. The first is to do nothing. Let the fire burn itself out. The second way is to send in the fire fighters.

Which approach is chosen will depend on what is at stake. If the forest fire does not threaten to spread to the big towns, then less dramatic measures are required. But if the fire is being helped along by strong winds and threatens to break containment and spread to neighborhoods and cities, then there is a lot more at stake. Fire-fighters will be called in from far and wide, and the state will use all measures at its disposal to put out the fire.

We have seen both approaches used in previous financial crises. The 1987 stock market crash, which was severe, did not spread, and therefore, doing almost nothing was the right thing to do. On the other hand, like in 1929, a financial crisis can lead to a Great Depression. In such a case, doing nothing could end up being very costly.

However, the fact that there is no universally applicable answer to which approach to take does not necessarily imply that there is not a certain set of rules which need to be applied to solve a crisis. In their seminal work on the Panic of 1907, the US economists Robert Brunner and Sean Carr emphasized how the failure of collective action could worsen and deepen a crisis.

In a nutshell, the Panic of 1907 was a financial crisis in the US, and especially in New York City, which was characterized by numerous runs on banks and other financial institutions. Back then, the Federal Reserve didn’t exist and therefore there wasn’t an obvious "lender of the last resort" – someone who could supply the fire fighters with unlimited amounts of water for their hosepipes. Therefore, there was also no obvious way to stop the crisis.

In this particular case it took the leadership of the legendary banker John Pierpont Morgan. He gathered around him a circle of influential New York bankers and forced them to form an association aimed at supporting the distressed financial institutions. Moreover, once this group was in place, there was a very strong commitment to draw a line in the sand and declare: "the trouble stops here".

Lessons from past crises show that to solve them we must see rule-based action, clear communication, a credible leading coalition, collaboration of private and public forces in an internationally coordinated fashion, unless we want the crisis to run its own course.

The current crisis reached a threshold in early October, where letting it run its own course was no longer a viable option. Sooner (rather than later) the crisis is going to stop because the authorities are going to do what is necessary to stop it. This is likely to include a broad rescue plan from the US and foreign governments, and their respective monetary authorities.

What is the individual investor to do? History shows that pulling out of the markets during a panic might be as costly for a broadly diversified investor as to go back in too early. Financial crises seldom die of old age. At some stage someone blows the whistle. This is the moment one needs to time correctly and for this, one needs to keep a cool head even if it seems that the world is falling apart.

During these volatile times stay focused on your long term goals. If you have a financial advisor, you should be in weekly contact with them. Take ownership of your financial future.

Provided by Wyn Yelin, Financial Advisor, UBS Financial Services Inc.

Written by Andreas Hoefert, global economist, UBS Wealth Management Research.