My friend was despondent: “I don’t know,” he said, “she is sending such mixed signals.” In economic affairs, as in those of the heart, an unclear signal can be worse than no signal. Citigroup, JPMorgan and Bank of America had better keep that in mind as they try to buoy the market for subprime debt.
Their intent in announcing a pool of some $80 billion, as the Financial Times described it last week, is to “allay fears of a downward price spiral that would hit the balance sheets of big lenders.” They may well succeed. But they also may scare the pants off investors. History shows it could go either way.
J.P. Morgan pulled it off in 1907. A severe financial panic swept the country. Banks failed, credit dried up and the stock market fell 50 percent. But Morgan stepped up to the plate and averted disaster. He used his own money to buy up blocks of stock and rescue shaky banks, and directed other big financiers to do the same. There was a bad recession, but it could have been much worse.
People were relieved, but skeptical about trusting the national economy to one plutocrat. The Federal Reserve Act of 1913 created a public institution to do what Morgan had done in 1907.
Flash forward to 1929. Stock prices hit a new high Sept. 3, but then started to decline. On Oct. 24, the market went into free-fall. The next day, big financiers huddled and decided to repeat 1907. Pooling money, they sent Richard Whitney, president of the New York Stock Exchange, out on the floor to buy up stocks. He bought a large block of U.S. Steel, offering much above the going price. He then bought big blocks in other blue chips. The market rallied, at least that day.
Over the weekend, however, investors across the country wondered, “What do these bigwigs know that I don’t know?” On Monday, sell orders rolled in. By Tuesday morning, telegraph lines across the country were heating up. The two-day drop was 25 percent. Prices continued to fall until they bottomed out in 1932 at 89 percent below peak. They didn’t get back to 1929 levels until 1954, despite 56 percent inflation over that interval.
Economists paid little attention to such “signaling” in the economy until 1973, when Michael Spence examined how employees try to convince their bosses they are superior prospects by paying for additional education themselves. He won the Nobel Prize in 2001 for this work.
From that seed, studies of signaling have mushroomed into all areas of economics and finance. It is one of the richest areas of research in the discipline. Such research shows that people often don’t all interpret signals clearly. The big investment banks need to keep this in mind as they step forward to build confidence in the market. They may scare the wits out of investors instead.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.